EH.net is owned and operated by the Economic History Association
with the support of other sponsoring organizations.

Deflation

Pierre L. Siklos, Wilfrid Laurier University

What is Deflation?

Deflation is a persistent fall in some generally followed aggregate indicator of price movements, such as the consumer price index or the GDP deflator. Generally, a one-time fall in the price level does not constitute a deflation. Instead, one has to see continuously falling prices for well over a year before concluding that the economy suffers from deflation. How long the fall has to continue before the public and policy makers conclude that the phenomenon is reflected in expectations of future price developments is open to question. For example, in Japan, which has the distinction of experiencing the longest post World War II period of deflation, it took several years for deflationary expectations to emerge.

Most observers tend to focus on changes in consumer or producer prices since, as far as monetary policy is concerned, central banks are responsible for ensuring some form of price stability (usually defined as inflation rates of +3% or less in much of the industrial world). However, sustained decreases in asset prices, such as for stock market shares or housing, can also pose serious economic problems since, other things equal, such outcomes imply lower wealth and, in turn, reduced consumption spending. While the connection between goods price and asset price inflation or deflation remains a contentious one in the economics profession, policy makers are undoubtedly worried about the existence of a link, as Alan Greenspan’s “irrational exuberance” remark of 1996 illustrates.

Historical and Contemporary Worries about Deflation

Until 2002, prospects for a deflation outside Japan remained unlikely. Prior to that time, deflation had been a phenomenon primarily of the 1930s and inextricably linked with the Great Depression, especially in the United States. Most observers viewed Japan’s deflation as part of a general economic malaise stemming from a mix of bad policy choices, bad politics, and a banking industry insolvency problem that would simply not go away. However, by 2001, reports of falling US producer prices, a sluggish economy, and the spread of deflation beyond Japan to China, Taiwan, and Hong Kong, to name a few countries, eventually led policy makers at the US Federal Reserve Board to publicly express their determination at avoiding deflation (e.g. See IMF 2003, Borio and Filardo 2004). Governor Bernanke of the US Federal Reserve raised the issue of deflation in late 2002 when he argued that the US public ought not to be overly worried since the Fed was on top of the issue and, in any event, the US was not Japan. Nevertheless, he also stressed that “central banks must today try to avoid major changes in the inflation rate in either direction. In central bank speak, we now face “symmetric” inflation risks.”1 The risks Governor Bernanke was referring to stem from the fact that, now that low inflation rates have been achieved, the public has to maintain the belief that central banks will neither allow inflation to creep up nor permit the onset of deflation. Even the IMF began to worry about the likelihood of deflation, as reflected in a major report, released in mid-2003, that assessed the probability that deflation might become a global phenomenon. While the risk that deflation might catch on in the US was deemed fairly low, the threat of deflation in Germany, for example, was viewed as being much greater.

Deflation in the Great Depression Era

It is evident from the foregoing illustrations that deflation has again emerged as public policy enemy number one in some circles. Most observers need only think back to the global depression of the 1930s, when the combination of a massive fall in output and the price level devastated the U.S. economy. While the Great Depression was a global phenomenon, actual output losses varied considerably from modest losses to the massive losses incurred by the U.S. economy. During the period 1928-1933 output fell by approximately 25% as did prices. Other countries, such as Canada and Germany, also suffered large output losses. Canada also experienced a fall in output of at least 25% over the same period while prices in 1933 were only about 78% of prices in 1928. In the case of Germany, the deflation rate over the same 1928-1933 period was similar to that experienced in Canada while output fell just over 20% in that time. No wonder analysts associate deflation with “ugly” economic consequences. Nevertheless, as shall see, there exist varieties of deflationary experiences. In any event, it needs to be underlined that the Great Depression period of the 1930s did not result in massive output losses worldwide. In particular, seminal analyses by Friedman and Schwartz (1982), and Meltzer (2003), concluded that the 1930s represented a deflationary episode driven by falling aggregate demand, compounded by poor policy choices by the leadership at the US Federal Reserve that was wedded at the time to a faulty ideology (a version of the ‘real bills’ doctrine2). Indeed, the competence of the interwar Fed has been the subject of considerable ongoing debate throughout the decades. Disagreements over the role of credit in deflation and concerns about how to reinvigorate the economy were, of course, also expressed in public at the time. Strikingly, the relationship between deflation and central bank policy was often entirely missing from the discussion, however.

The Debt-Deflation Problem

The prevailing ideology treated the occasional deflation as one that acted as a necessary spur for economic growth, a symptom of economic health, not one indicative of economic malaise. However, there were notable exceptions to the chorus of views favorable to deflation. Irving Fisher developed what is now referred to as the “debt-deflation” hypothesis. Falling prices increase the debt burden and adversely affect firms’ balance sheets. This was particularly true of the plight faced by farmers in many countries, including the United States, during the 1920s when falling agricultural prices combined with tight monetary policies sharply raised the costs of servicing existing debts. The same was true of the prices of raw materials. The Table below illustrates the rather precipitous drop in the price level of some key commodities in a single year.

Table 1
Commodity Prices in the U.S., 1923-24

Commodity Group May 1924 May 1923
All commodities 147 156
Farm Products 136 139
Foods 137 144
Clothes and Clothing 187 201
Fuel and Lighting 177 190
Metals 134 152
Building Materials 180 202
Chemicals and drugs 127 134
House furnishings 173 187
Miscellaneous 112 125
Source: Federal Reserve Bulletin, July 1924, p. 532.
Note: Prices in 1913 are defined to equal 100

The Postponing Purchases Problem

Hence, a deflation is a harbinger of a financial crisis with repercussions for the economy as a whole. Others, such as Keynes, also worried about the impact of deflation on aggregate demand in the economy, as individuals and firms postpone their purchases in the hopes of purchasing durable goods especially at lower future prices. He actually advocated a policy that is not too dissimilar to what we would refer to today as inflation targeting (e.g., see Burdekin and Siklos 2004, ch. 1). Unfortunately, the prevailing ideology was that deflation was a purgative of sorts, that is, the price to be paid for economic excesses during the boom years, and necessary to establish to conditions for economic recovery. The reason is that economic booms were believed to be associated with excessive inflation which had to be rooted out of the system. Hence, prices that rose too fast could only be cured if they returned to lower levels.

Not All Deflations Are Bad

So, are all deflations bad? Not necessarily. The United Kingdom experienced several years of falling prices in the 1870-1939. However, since the deflation was apparently largely anticipated (e.g., see Capie and Wood 2004) the deflation did not produce adverse economic consequences. Finally, an economy that experiences a surge of financial and technological innovations would effectively see rising aggregate supply that, with only modest growth in aggregate demand, would translate into lower prices over time. Indeed, estimates based on simple relationships suggest that the sometime calamitous effects that are thought to be associated with deflation can largely be explained by the rather unique event of the Great Depression of the 1930s (Burdekin and Siklos 2004, ch. 1). However, the other difficulty is that a deflation may at first appear to be supply driven until policy makers come to the realization that aggregate demand is the proximate cause. This seems to be the case of the modern-day episodes of deflation in Japan and China.

Differences between the 1930s and Today

What’s different about the prospects of a deflation today? First, and perhaps most obviously, we know considerably more than in the 1930s about the transmission mechanism of monetary policy decisions. Second, the prevailing economic ideology favors flexible exchange rates. Almost all of the countries that suffered from the Great Depression adhered to some form of fixed exchange rates, usually under the aegis of the Gold Standard. As a result, the transmission of deflation from one country to another was much stronger than under flexible exchange rate conditions. Third, policy makers have many more instruments of policy today than seventy years ago. Not only can monetary policy be more effective when correctly applied, but fiscal policy exists on a scale that was not possible during the 1930s. Nevertheless, fiscal policy, if misused, as has apparently been the case in Japan, can actually add to the difficulties of extricating an economy out of deflationary slump. There are similar worries about the US case as the anticipated surpluses have turned into large deficits for the foreseeable future. Likewise the fiscal rules adopted by the European Union severely hinder, even altogether prevent some would say, the scope for a stimulative fiscal policy. Fourth, policy-making institutions are both more open and accountable than in past decades. Central banks are autonomous and accountable and their efforts at making monetary policy more transparent to financial markets ought to reduce the likelihood of serious policy errors as these are considered to be powerful devices to enhance credibility.

Parallels between the 1930s and Today

Nevertheless, in spite of the obvious differences between the situation today and the ones faced seven decades ago, some parallels remain. For example, until 2000, many policy makers, including the central bankers at the Fed, felt that the technological developments of the 1990s might lead to economic growth almost without end and, in this “new” era, the prospect of a bad deflation seemed the furthest thing on their minds. Similarly, the Bank of Japan was long convinced that their deflation was of the good variety. It has taken its policy makers a decade to recognize the seriousness of their situation. In Japan, the debate over the menu of needed reforms and policies to extricate the economy from its deflationary trap continues unabated. Worse still the recent Japanese experience raises the specter of Keynes’ famous liquidity trap (Krugman 1998), namely a state of affairs where lower interest rates are unable to stimulate investment or economic activity more generally. Hence, deflation, combined with expectations of falling prices, conspires to make the so-called ‘zero lower bound’ for nominal interest rates an increasingly binding one (see below).

Two More Concerns: Labor Market and Credit Market Impacts of Deflation

There are at least two other reasons to worry about the onset of a deflation with devastating economic consequences. Labor markets exhibit considerably less flexibility than several decades ago. Consequently, it is considerably more difficult for the necessary fall in nominal wages to match a drop in prices. Otherwise, real wages would actually rise in a deflation and this would produce even more slack in the labor market with the resulting increases in the unemployment rate contributing to further reduce aggregate demand, the exact opposite of what is needed. A second consideration is the ability of monetary policy to stimulate the economy when interest rates are close to zero. The so-called “zero lower bound” constraint for interest rates means that if the rate of deflation rises so do real interest rates further depressing aggregate demand. Therefore, while history need not repeat itself, the mistakes of the past need to be kept firmly in mind.

Frequency of Deflation in the Historical Record

As noted above, inflation has been an all too common occurrence since 1945. The table below shows that deflation has become a much less common feature of the macroeconomic landscape. One has to go back to the 1930s before encountering successive years of deflation.3 Indeed, for the countries listed below, the number of times prices fell year over year for two years or more is a relatively small number. Hence, deflation is a fairly unusual event.

Table 2: Episodes of Deflation from the mid-1800s to 1945

Country
(year record begins)
Number of
occurrences of
deflation
until 1945
Years of persistent deflation/Crisis
Austria (1915) 1
Australia (1862) 5 BC: 1893
CC: 1933-33
Belgium (1851) 9 1892-96
BC, CC: 1924-26
1931-35, BC: 1931
BC,CC: 1934-35
Canada (1914) 2 CC: 1891,1893, 1908, 1921, 1929-31
1930-33
Denmark (1851) 9 1882-86, BC: 1885, 1892-96, BC: 1907-08
1921-32, BC, CC: 1921-22, 1931-32
Finland (1915) 1 BC: 1900,1921 1929-34, BC, CC: 1931-32
France (1851) 4 CC, BC: 1888-89, 1907, 1923, 1926
1932-35, BC: 1930-32
Germany (1851) 8 1892-96, BC, CC:1893, 1901,1907
1930-33, BC, CC: 1931, 1934
Ireland (1923) 2 1930-33
Italy (1862) 6 1881-84, BC, CC: 1891, 1893-94, 1907-08, 1921
1930-34, BC: 1930-31, 1934-35
Japan (1923) 1 CC, BC: 1900-01, 1907-08, 1921
1925-31, BC, CC: 1931-32
Netherlands (1881) 6 1893-96, BC, CC: 1897, 1921
1930-32
CC, BC: 1935, 1939
Norway (1902) 2 BC, CC: 1891, 1921-23
1926-33, BC CC: 1931
New Zealand (1908) 1 BC: 1920, 1924-25
1929-33, BC, CC: 1931
Spain (1915) 2
Sweden (1851) 9 1882-87
1930-33
Switzerland (1891) 4 1930-34
UK (1851) 8 1884-87
1926-33
US (1851) 9 1875-79
1930-33

Notes: Data are from chapter 1, Richard C.K. Burdekin and Pierre L. Siklos, editors, Deflation: Current and Historical Perspectives, New York: Cambridge University Press, 2004. The numbers in parenthesis in the first column refer to the first year for which we have data. The second column gives the frequency of occurrences of deflation defined as two or more consecutive years with falling prices. The last column provides some illustrations of especially persistent declines in the price level, defined in terms of consumer prices. In italics, years with currency crises (CC) or banking crises (BC), are shown where data are available. The dates are from Michael D. Bordo, Barry Eichengreen, Daniela Klingebiel, and Maria Soledad Martinez-Peria, “Financial Crises: Lessons from the Last 120 Years,” Economic Policy, April 2001.

Is There an Empirical Deflation-Recession Link?

If that is indeed the case why has there been so much concern expressed over the possibility of renewed deflation? One reason is the mediocre economic performance that has been associated with the Japan’s deflation. Furthermore, the foregoing table makes clear that in a number of countries the 1930s deflation was associated with the Great Depression. Indeed, as the Table also indicates for countries where we have data, the Great Depression represented a combination of several crises, simultaneously financial and economic in nature. However, it is also clear that deflation need not always be associated either with a currency crisis or a banking crisis. Since the Great Depression was a singularly devastating event from an economic perspective, it is not entirely surprising that observers would associate deflation with depression.

But is this necessarily so? After all, the era roughly from 1870 to 1890 was also a period of deflation in several countries and, as the figure below suggests, in the United States and elsewhere, deflation was accompanied by strong economic growth. It is what some economists might refer to as a “good” deflation since it occurred at a time of tremendous technological improvements (in transportation and communications especially). That is not to say, even under such circumstances, that opposition from some quarters over the effects of such developments was unheard of. Indeed, the deflation prompted some, most famously William Jennings Bryan in the United States, to run for office believing that the Gold Standard’s proclivity to create deflation was akin to crucifying “mankind upon a cross of gold.” In contrast, the Great Depression would be characterized as a “bad” or even “ugly” deflation since it is associated with a great deal of slack in the economy.

Figure 1
Prices Changes versus the Output Gap, 1870s and 1930s

Notes: The top figure plots the rate of CPI inflation for the periods 1875-79 and 1929-33 for the United States. The bottom figure is an estimate of the output gap for the U.S., that is, the difference between actual and potential real GDP. A negative number signifies actual real GDP is higher than potential real GDP and vice-versa when the output gap is positive. See Burdekin and Siklos (2004) for the details. The vertical line captures the gap in the data, as observations for 1880-1929 are not plotted.

Conclusions

Whereas policy makers today speak of the need to avoid deflation their assessment is colored by the experience of the bad deflation of the 1930s, and its spread internationally, and the ongoing deflation in Japan. Hence, not only do policy makers worry about deflation proper they also worry about its spread on a global scale.

If ideology can blind policymakers to introducing necessary reforms then the second lesson from history is that, once entrenched, expectations of deflation may be difficult to reverse. The occasional fall in aggregate prices is unlikely to significantly affect longer-term expectations of inflation. This is especially true if the monetary authority is independent from political control, and if the central bank is required to meet some kind of inflation objective. Indeed, many analysts have repeatedly suggested the need to introduce an inflation target for Japan. While the Japanese have responded by stating that inflation targeting alone is incapable of helping the economy escape from deflation, the Bank of Japan’s stubborn refusal to adopt such a monetary policy strategy signals an unwillingness to commit to a different monetary policy strategy. Hence, expectations are even more unlikely to be influenced by other policies ostensibly meant to reverse the course of Japanese prices. The Federal Reserve, of course, does not have a formal inflation target but has repeatedly stated that its policies are meant to control inflation within a 0-3% band. Whether formal versus informal inflation targets represent substantially different monetary policy strategies continues to be debated, though the growing popularity of this type of monetary policy strategy suggests that it greatly assists in anchoring expectations of inflation.

References

Borio, Claudio, and Andrew Filardo. “Back to the Future? Assessing the Deflation Record.” Bank for International Settlements, March 2004.

Burdekin, Richard C.K., and Pierre L. Siklos. “Fears of Deflation and Policy Responses Then and Now.” In Deflation: Current and Historical Perspectives, edited by Richard C.K. Burdekin and Pierre L. Siklos. New York: Cambridge: Cambridge University Press, 2004.

Capie, Forrest, and Geoffrey Wood. “Price Change, Financial Stability, and the British Economy, 1870-1939.” In Deflation: Current and Historical Perspectives, edited by Richard C.K. Burdekin and Pierre L. Siklos. New York: Cambridge: Cambridge University Press, 2004.

Friedman, Milton, and Anna J. Schwartz. Monetary Trends in the United States and the United Kingdom. Chicago: University of Chicago Press, 1982.

Humphrey, Thomas M. “The Real Bills Doctrine.” Federal Reserve Bank of Richmond Economic Review 68, no. 5 (1982).

International Monetary Fund. “Deflation: Determinants, Risks, and Policy Options “Findings of an Independent Task Force.” April 30, 2003.

Krugman, Paul. “Its Baaaaack: Japan’s Slump and the Return of the Liquidity Trap.” Brookings Papers on Economic Activity 2 (1998): 137-205.

Meltzer, Allan H. A History of the Federal Reserve. Chicago: Chicago University Press, 2003.

Citation: Siklos, Pierre. “Deflation”. EH.Net Encyclopedia, edited by Robert Whaples. May 11, 2004. URL http://eh.net/encyclopedia/deflation/

Debt, Innovations, and Deflation: The Theories of Veblen, Fisher, Schumpeter, and Minsky

Author(s):Raines, J. Patrick
Leathers, Charles G.
Reviewer(s):Kaboub, Fadhel

Published by EH.NET (September 2010)

J. Patrick Raines and Charles G. Leathers, Debt, Innovations, and Deflation: The Theories of Veblen, Fisher, Schumpeter, and Minsky. Cheltenham, UK: Edward Elgar, 2008. xiii + 191 pp. $100 (hardcover), ISBN: 978-1-84542-785-6.

Reviewed for EH.NET by Fadhel Kaboub, Department of Economics, Denison University

J. Patrick Raines and Charles G. Leathers have produced a remarkable book on a very timely subject, namely the interplay between debt, innovations, and deflation. The authors recognize that little is being said about the causes of deflationary pressure in today?s economy. Therefore, they set out to provide a fresh critical assessment of the deflation theories of Thorstein Veblen, Irving Fisher, Joseph Schumpeter, and Hyman Minsky in light of the growing concern about deflation in the early 2000s in the United States.

For this purpose, the authors focus on three fundamental questions. First, Raines and Leathers determine the four economists? explanations of the causes of deflation and how those explanations relate to the historical context of their writings on deflation. Second, they establish the extent to which those four theories have common points and complementarities. Third, the authors lay out the analytical and policy lessons to be taken from this study to analyze the concerns about deflation in 2002-2003.

The book is organized in six main sections in addition to the introduction and a concluding section. Chapter 2 underscores the importance of the research question that Raines and Leathers are undertaking in this book. The authors provide a very concise analytical overview of the emergence of deflation as a monetary policy issue in the 2003-2004 period. They argue that the 1940-2000 period was dominated by concerns over inflation. Raines and Leathers point out that Alan Greenspan, however, began referring to deflationary tendencies as early as 1998, initially as an academic issue, and later as a matter of concern to policymakers. His main conclusion was that deflation is a monetary phenomenon in the long run. The authors highlight that in the brief period of concern over disinflation and deflation, neither Greenspan nor Ben Bernanke addressed the causes of deflation but merely focused on its likelihood and its consequences.

In chapter 3, Raines and Leathers review the mainstream theory of deflation based on the classical interpretation of the quantity theory of money. In addition to Fisher?s interpretation of the quantity theory, the authors assess the ?deflation? theories put forward by Adam Smith, John Stuart Mill, and Thomas Tooke. The chapter ends with an overview of the monetary theories of business cycles of R.G. Hawtrey and Friedrich von Hayek.

Chapters 4, 5, 6, and 7 respectively dissect the theories of Veblen, Fisher, Schumpeter, and Minsky. These chapters are excellent stand-alone readings for an advanced undergraduate or a graduate course on the four economists in question. Their scholarship is succinctly laid out, and the literature is thoroughly and critically reviewed. The strength of these chapters is the historical contextualization of the deflation theories developed by Veblen, Fisher, Schumpeter, and Minsky. Chapter 8 is where the entire book comes together in a meaningful way. It provides a comparative summary of the analysis made in chapters 4 through 7. This is by far the most interesting chapter of the book. Here, Raines and Leathers identify two main categories accounting for the differences among the four economists. First, there are evolutionary changes in the institutional structure of the economy that must be accounted for; and second, there are differences in methodologies and normative perspectives that cannot be reconciled. Veblen and Schumpeter are identified as the two extremes on the spectrum of the book, despite sharing an evolutionary analysis of the role of technological innovation in the development of capitalism; what sets them apart is the way they treat business values and institutions. Fisher and Minsky are placed somewhat in between, with Fisher?s descriptive theory of deflation closer to Schumpeter; and Minsky?s financial instability hypothesis closer to Veblen?s evolutionary analysis. The authors conclude that when taking all four theories together, we could have a better understanding of the causes of deflation and be able to develop the appropriate policies to deal with it. This is especially important in an era in which (technological and financial) innovation and debt play an increasing role in the structure of the U.S. economy.

The shortcomings of the book are mentioned here in the spirit of unsatisfied curiosity. First, the choice of Veblen, Fisher, Schumpeter, and Minsky remains somewhat unexplained. Why not Keynes or Marx? Second, the book is exclusively focused on the U.S. experience with deflation; one would have liked a discussion of Japan?s experience with deflation in the 1990s, for instance. Third, the focus on the Fed?s treatment of deflation seems to be the initial motivation for writing the book, but somehow it remains as an add-on theme, albeit an interesting one, that only appears in the beginning and at the very end of the book. This makes the thesis of the book a bit too broad, and suggests that there are perhaps two competing book ideas — one on the deflation theories of Veblen, Fisher, Schumpeter, and Minsky; and another on the Fed?s treatment of deflation concerns. In sum, the book is a valuable contribution to the literature on the causes of deflation, and how it has been treated by the Fed.

Fadhel Kaboub is an Assistant Professor of Economics at Denison University, and a Research Associate at the Levy Economics Institute, the Center for Full Employment and Price Stability, and the International Economic Policy Institute. His research focuses on the political economy of full employment policies, monetary theory and policy, and economic development.

Copyright (c) 2010 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (September 2010). All EH.Net reviews are archived at http://www.eh.net/BookReview.

Subject(s):History of Economic Thought; Methodology
Geographic Area(s):General, International, or Comparative
Time Period(s):20th Century: Pre WWII
20th Century: WWII and post-WWII

Debt, Innovations, and Deflation: The Theories of Veblen, Fisher, Schumpeter, and Minsky

Author(s):Raines, J. Patrick
Leathers, Charles G.
Reviewer(s):Kaboub, Fadhel

Published by EH.NET (September 2010)

J. Patrick Raines and Charles G. Leathers, Debt, Innovations, and Deflation: The Theories of Veblen, Fisher, Schumpeter, and Minsky. Cheltenham, UK: Edward Elgar, 2008. xiii + 191 pp. $100 (hardcover), ISBN: 978-1-84542-785-6.

Reviewed for EH.NET by Fadhel Kaboub, Department of Economics, Denison University

J. Patrick Raines and Charles G. Leathers have produced a remarkable book on a very timely subject, namely the interplay between debt, innovations, and deflation. The authors recognize that little is being said about the causes of deflationary pressure in today?s economy. Therefore, they set out to provide a fresh critical assessment of the deflation theories of Thorstein Veblen, Irving Fisher, Joseph Schumpeter, and Hyman Minsky in light of the growing concern about deflation in the early 2000s in the United States.

For this purpose, the authors focus on three fundamental questions. First, Raines and Leathers determine the four economists? explanations of the causes of deflation and how those explanations relate to the historical context of their writings on deflation. Second, they establish the extent to which those four theories have common points and complementarities. Third, the authors lay out the analytical and policy lessons to be taken from this study to analyze the concerns about deflation in 2002-2003.

The book is organized in six main sections in addition to the introduction and a concluding section. Chapter 2 underscores the importance of the research question that Raines and Leathers are undertaking in this book. The authors provide a very concise analytical overview of the emergence of deflation as a monetary policy issue in the 2003-2004 period. They argue that the 1940-2000 period was dominated by concerns over inflation. Raines and Leathers point out that Alan Greenspan, however, began referring to deflationary tendencies as early as 1998, initially as an academic issue, and later as a matter of concern to policymakers. His main conclusion was that deflation is a monetary phenomenon in the long run. The authors highlight that in the brief period of concern over disinflation and deflation, neither Greenspan nor Ben Bernanke addressed the causes of deflation but merely focused on its likelihood and its consequences.

In chapter 3, Raines and Leathers review the mainstream theory of deflation based on the classical interpretation of the quantity theory of money. In addition to Fisher?s interpretation of the quantity theory, the authors assess the ?deflation? theories put forward by Adam Smith, John Stuart Mill, and Thomas Tooke. The chapter ends with an overview of the monetary theories of business cycles of R.G. Hawtrey and Friedrich von Hayek.

Chapters 4, 5, 6, and 7 respectively dissect the theories of Veblen, Fisher, Schumpeter, and Minsky. These chapters are excellent stand-alone readings for an advanced undergraduate or a graduate course on the four economists in question. Their scholarship is succinctly laid out, and the literature is thoroughly and critically reviewed. The strength of these chapters is the historical contextualization of the deflation theories developed by Veblen, Fisher, Schumpeter, and Minsky. Chapter 8 is where the entire book comes together in a meaningful way. It provides a comparative summary of the analysis made in chapters 4 through 7. This is by far the most interesting chapter of the book. Here, Raines and Leathers identify two main categories accounting for the differences among the four economists. First, there are evolutionary changes in the institutional structure of the economy that must be accounted for; and second, there are differences in methodologies and normative perspectives that cannot be reconciled. Veblen and Schumpeter are identified as the two extremes on the spectrum of the book, despite sharing an evolutionary analysis of the role of technological innovation in the development of capitalism; what sets them apart is the way they treat business values and institutions. Fisher and Minsky are placed somewhat in between, with Fisher?s descriptive theory of deflation closer to Schumpeter; and Minsky?s financial instability hypothesis closer to Veblen?s evolutionary analysis. The authors conclude that when taking all four theories together, we could have a better understanding of the causes of deflation and be able to develop the appropriate policies to deal with it. This is especially important in an era in which (technological and financial) innovation and debt play an increasing role in the structure of the U.S. economy.

The shortcomings of the book are mentioned here in the spirit of unsatisfied curiosity. First, the choice of Veblen, Fisher, Schumpeter, and Minsky remains somewhat unexplained. Why not Keynes or Marx? Second, the book is exclusively focused on the U.S. experience with deflation; one would have liked a discussion of Japan?s experience with deflation in the 1990s, for instance. Third, the focus on the Fed?s treatment of deflation seems to be the initial motivation for writing the book, but somehow it remains as an add-on theme, albeit an interesting one, that only appears in the beginning and at the very end of the book. This makes the thesis of the book a bit too broad, and suggests that there are perhaps two competing book ideas — one on the deflation theories of Veblen, Fisher, Schumpeter, and Minsky; and another on the Fed?s treatment of deflation concerns. In sum, the book is a valuable contribution to the literature on the causes of deflation, and how it has been treated by the Fed.

Fadhel Kaboub is an Assistant Professor of Economics at Denison University, and a Research Associate at the Levy Economics Institute, the Center for Full Employment and Price Stability, and the International Economic Policy Institute. His research focuses on the political economy of full employment policies, monetary theory and policy, and economic development.

Copyright (c) 2010 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (September 2010). All EH.Net reviews are archived at http://www.eh.net/BookReview.

Subject(s):Financial Markets, Financial Institutions, and Monetary History
History of Economic Thought; Methodology
Geographic Area(s):Europe
North America
Time Period(s):20th Century: Pre WWII
20th Century: WWII and post-WWII

Deflation: Current and Historical Perspectives

Author(s):Burdekin, Richard C.K.
Siklos, Pierre L.
Reviewer(s):Mitchener, Kris James

Published by EH.NET (November 2005)

?

Richard C.K. Burdekin and Pierre L. Siklos, editors, Deflation: Current and Historical Perspectives. Cambridge: Cambridge University Press, 2004. xxii + 359 pp. $75 (cloth), ISBN: 0-521-83799-5.

Reviewed for EH.NET by Kris James Mitchener, Department of Economics, Santa Clara University,

With oil prices accelerating rapidly over the past year, housing prices “frothing” in coastal areas, and the Federal Reserve raising the federal funds rate twelve times since the end of the most recent recession, the timing of a new book addressing the topic of deflation seems somewhat inopportune. Nevertheless, it is worth remembering that, as little as two years ago, American policy makers were seriously pondering the possibility of deflation. Improvements in labor productivity and the expanding use of global supply chains to manage input costs were holding the lid on the overall price level, and short-term interest rates were approaching the zero bound in the wake of the 2001 recession and the collapse in spending on information technologies. Such circumstances warranted the consideration of the small-probability event of sustained deflation, given Alan Greenspan’s risk-management approach to central banking. Deflation and related issues such as asset price booms and busts, liquidity traps, and the operation of monetary policy in extremely low interest-rate environments consequently received renewed attention from domestic policymakers and economists. Moreover, policy debates over the effects of deflation and the appropriate response to it had been taking place for some time in other parts of the world. In particular, Japan was bearing witness to the first recorded deflation in an industrialized country since the Great Depression. These issues and policy debates form the backdrop for the edited volume by Richard Burdekin and Pierre Siklos, which offers a critical evaluation of historical episodes of deflation and some long-run perspective on more recent events.

The edited conference volume consists of twelve chapters that examine deflation by drawing on theory, history, and empirical evidence. The book features interesting contributions by many eminent financial and economic historians. This alone would make it appealing to specialists working in macroeconomic history, but it ought to attract a broader readership, including macroeconomists, central bankers, and policymakers, since the editors were careful to include papers that employ more recent data and theory. Indeed, one of the strengths of the volume is that the contributors employ a variety of methodological perspectives to analyze monetary phenomena and compare present issues with past episodes of deflation.

After an introductory chapter that provides a useful summary by the editors, the book is divided into four sections. The first part of the book, entitled “Fears of Deflation and the Role of Monetary Policy,” begins with an essay by Hugh Rockoff. He suggests that the U.S. bank failures of the 1930s exhibit characteristics that are similar to twin crises (banking and exchange rate crises) that have occurred more recently in national economies. Rural regions in the U.S. experienced “capital flight” because depositors feared that declining export prices and demand would undermine the ability of borrowers to repay; this eventually prompted runs on some banks and led authorities to impose restrictions on withdrawals (bank holidays). Rockoff contributes to the growing literature on regional differences in bank performance during the Great Depression by focusing on “silent runs” — the withdrawal of deposits from rural areas and their movement to Eastern financial centers — a process that was driven in part by declining prices and deflation. The interregional evidence is consistent with his argument, although individual bank data showing that losses of deposits had important consequences for the survival of banks would further strengthen his argument.

In the second chapter of this section, Forrest Capie and Geoffrey Wood take a longer-run perspective and examine whether debt-deflation had damaging effects on the British economy between 1870 and the 1930s. J.M. Keynes’ views on debt deflation suggested that expected real rates are important for generating real effects, whereas Fisher emphasized that rising realized rates produced dilatory effects on existing debtors. The authors use simple time-series analysis to produce price-expectation series and then construct real interest rates that take into account either expected inflation or actual inflation, according to the respective ideas of Keynes and Fisher. They use these series as well as bond spreads to assess the effects of debt deflation, and find little statistical evidence that debt-deflation in Britain created adverse effects for the real economy (or for financial stability). The authors rightly point out, however, that Britain’s experience with deflation was much milder than that which occurred in the U.S., so it is difficult to rule out the debt-deflation hypothesis in general.

Klas Fregert and Lars Jonung close out the first section of the book by examining two cases of interwar deflation in Sweden, 1921-23 and 1931-33. They use the relatively short interval of time between these two episodes to assess how policymaking and macroeconomic outcomes in the first episode were influenced by the inflationary period of World War I, and how this deflationary episode (and the persistent and high unemployment that emerged in the 1920s) in turn influenced beliefs and behavior ten years later. Fregert and Jonung employ qualitative evidence to argue that the large deflation in the early 1920s greatly influenced the thinking of economists, policymakers, and wage setters in the latter episode. Heterogeneous expectations across these groups limited the deflation of 1931-33 as wage contracts were shortened and, in some cases, abandoned.

The second section of the book, entitled “Deflation and Asset Prices,” provides new contributions to the growing literature examining the relationship between monetary policy and asset prices. The first, by Michael Bordo and Olivier Jeanne, develops a model to assess whether monetary policymakers should respond to an asset price “boom” — a term which, according to the authors, differs from a “bubble” in that it is not necessary for policymakers to determine if asset prices reflect fundamentals in order to act. If monetary policies decide not to lean against the wind, they run the risk of a boom being followed by a bust, and a collateral-induced credit crunch dampening the real economy. On the other hand, pursuing restrictive monetary policy implies immediate costs in terms of lower output and inflation. Although the model is very stylized, they find that a proactive monetary policy is optimal when the risk of a bust is large and the monetary authorities can let the air out at a low cost; moreover, they argue that such a policy rule will not look like a Taylor rule in that it will depend on the risks in the balance sheets of the private sector. They then present some preliminary empirical evidence that the boom-bust cycles of their model appear to be much more frequent in real property prices than in stock prices and more common in small countries than in large. (The obvious exceptions to this are Japan’s experience in the 1990s and the U.S. during the Great Depression.) Moreover, they suggest that such busts can create banking crises and lead to severe reductions in output.

The second chapter in this section also examines boom-bust cycles in credit markets, but focuses on the linkages between bank lending and asset prices. Using vector autoregressions, Charles Goodhart and Boris Hofmann argue that movements in property prices during the period 1985-2001 had significant effects on bank lending in a sample of twelve developed countries. Their impulse response functions, however, show that bank lending appears to be insensitive to changes in interest rates. On the other hand, asset prices seem to respond negatively to interest-rate movements. The authors provocatively conclude that there is limited scope for effectively using monetary policy as an instrument to provide financial stability in periods when there are asset-price swings, in part because the effects of interest rates on asset prices and bank lending are highly nonlinear. One challenge to their interpretation of the evidence is that monetary policy is treated in isolation from changes in bank regulation that also took place during this period. Regulatory changes likely also influenced bank lending decisions. One prominent example of this was the adoption of BIS capital-asset requirements in 1988 by Japanese banks, which strengthened the relationship between bank lending and equity prices. Banks could count 45 percent of latent capital as part of tier-II capital requirements; this ensured that increases in equity prices increased bank capital, which in turn, encouraged banks to lend more on real estate and supported rising asset prices.

The third part of the book provides additional case studies of deflation. Michael Bordo and Angela Redish point out that “good” deflations are often defined as periods when prices are falling as a result of positive supply shocks (like technological progress); hence, aggregate supply outpaces aggregate demand. “Bad deflations” are periods when prices fall because aggregate demand increases faster than aggregate supply; this can occur when there are money demand shocks. They suggest, however, that this simple classification can be difficult to square with empirical evidence. Examining the United States and Canada during the classical gold standard period, they find some evidence that both negative demand shocks and positive supply shocks drove prices downward between 1870 and 1896. Output growth was more rapid during the inflationary period of 1896-1913 than the preceding period of deflation, but their time series evidence suggests that there was no causal relationship: price changes were not driving the determination of output.

Michele Fratianni and Franco Spinelli look at Italian deflation and exchange-rate policy during the interwar period, and Michael Hutchinson analyzes Japan in the 1990s. These two chapters make use of a comparative historical approach. Fratianni and Spinelli compare and contrast the Italian deflation of 1927-33 with the disinflation that took place during the adoption of the EMS (1987-92) to argue that fixed exchange rates became unsustainable as economic fundamentals deteriorated. In particular, the interwar gold-exchange standard imparted a deflationary bias, which eventually led authorities to abandon the fixed exchange rate regime in order to pursue lender of last resort activities (thereby assisting failing banks and preventing banking panics) and stabilize the money supply. Hutchinson provides a nice overview of the most important recent episode of deflation, Japan, and shows how injections of liquidity by the central bank (which eventually reduced nominal rates to zero) have not been very effective at improving the growth in broad money aggregates (at least until the last few years). He examines both the liquidity trap and “credit crunch” views of the Heisei Malaise, and argues that, in spite of some policy mistakes that prolonged the deflation and made it more costly, Japan’s deflationary experience has been nowhere near as disastrous as the experience of the U.S. in the 1930s. However, Hutchinson suggests that Japanese policymakers could have made their commitment to zero-interest-rate policy more effective by also adopting an explicit inflation target.

The last section provides three studies that explore the behavior of asset prices during deflations. Lance Davis, Larry Neal, and Eugene White examine how the 1890s deflation affected the core financial markets of the time. Largely narrative in its treatment, this chapter examines how the corresponding financial crisis of that decade prompted different degrees of institutional redesign and regulation in the financial markets of Paris, Berlin, New York, and London. In the next chapter, Martin Bohl and Pierre Siklos study the behavior of German equity prices during the 1910s and 1920s. They argue that this period of German history is particularly useful for analyzing the long-run validity of the present value model of asset price determination because the model can be studied for periods of deflation and hyperinflation. Their empirical results suggest that, while the theory holds for the long run, German share prices exhibited large and persistent deviations in the short run, perhaps the result of noise trading or bubbles. The final chapter by Richard Burdekin and Marc Weidenmier suggests that gold stocks might be a useful hedge against asset price deflation. They find evidence of excess returns on gold stocks after the 1929 and 2000 equity-market declines, but scant evidence of excess returns after the 1987 crash, and interpret these results as indicating that gold stocks only serve a useful hedge if asset price reversals are prolonged.

Even though deflation has lost some of its immediate relevance to policymakers, there is much to be commended in the editors’ efforts to design a book that demonstrates the importance of developing a greater empirical and theoretical understanding of deflation. Although one can always quibble with the compromises that occur when assembling such a volume (for example, in this book, despite the fact that many of the chapters discuss the interwar period, there is no single chapter that attempts to examine deflation using a true panel-data approach), this book’s chapters certainly have enough thematic overlap that the sum of the articles still ends up being of greater value than the individual parts — something that is often difficult to achieve in conference volumes. In this respect, it is a welcome addition to the literature for those interested in monetary economics or those wanting an enhanced historical perspective on recent policy debates.

Kris James Mitchener is assistant professor of economics and Dean Witter Foundation Fellow in the Leavey School of Business, Santa Clara University, as well as a Faculty Research Fellow with the National Bureau of Economic Research. He is currently researching sovereign debt crises during the classical gold standard period and the effects of supervision and regulation on financial stability and growth. Recent publications include “Bank Supervision, Regulation, and Financial Instability during the Great Depression,” Journal of Economic History (March 2005) and “Empire, Public Goods, and the Roosevelt Corollary” (with Marc Weidenmier), Journal of Economic History (September 2005).

?

Subject(s):Macroeconomics and Fluctuations
Geographic Area(s):General, International, or Comparative
Time Period(s):20th Century: WWII and post-WWII

Crash! How the Economic Boom and Bust of the 1920s Worked

Author(s):Payne, Phillip G.
Reviewer(s):Parker, Randall

Published by EH.Net (September 2017)

Phillip G. Payne, Crash! How the Economic Boom and Bust of the 1920s Worked. Baltimore: Johns Hopkins University Press, 2015. viii +142 pp. $20 (paperback), ISBN: 978-1-4214-1856-8.

Reviewed for EH.Net by Randall Parker, Department of Economics, East Carolina University.

 

Crash! is a part of the “How Things Worked” series being published by Johns Hopkins University Press. The list of books included in this series is not particularly long (at least not yet) and includes books on Ellis Island, sod busting, and Union Army recruitment of U.S. colored troops, among other topics. I like the idea behind this series, and the editors have really done themselves proud by having Phillip Payne author this book on the boom and bust of the 1920s. It is the first entry in the series pertaining to economic history.

Payne is a professor of history at St. Bonaventure University. If the idea behind the “How Things Worked” series is to produce non-technical books that provide useful road maps that hit the high points of historical epochs and give undergraduates the fundamental knowledge they need to understand the basics of what went on and why, then Crash! accomplishes what it sets out to do. Payne provides an in-depth look at the 1920s and the emergence of speculation and how the culture and economy of the time promoted that unhealthy trait (that still afflicts us today and ever shall). All the usual suspects and their stories are told: James Riordan and Ivar Kreuger (and others who did themselves in), Richard Whitney and his attempt to save U.S. Steel share prices, J.P. Morgan and others. The roles they played in bringing about the unfortunate events of 1929 and the beginning of the Depression with the stock market crash are described with historical elegance and come alive in the words of Payne. The level of detail of the events and the actors that made them happen represent a new and fresh look at a familiar, and certainly guilty, culprit in helping to bring about the Great Depression.

The last thirty pages of the book are also a road map for the essential elements of the recovery from the Depression, the emergence and governance of Franklin Roosevelt and the New Deal, plus an Epilogue comparing the 1920s to the malaise we endured in 2008. Correctly saying “How This Time Is (Not) Different,” we are reminded that this pattern will almost certainly repeat sometime down the road.

There are some particularly enlightening parts of the book. The West Virginia Coal Wars in the early 1920s and the use of air power against American civilians is not something economists hear much about. But the shock I felt when I read about it cannot be overstated. Moreover, I had forgotten that Herbert Hoover blamed World War I for the Great Depression. Payne reminds us that it was not Peter Temin who originally made this connection, although Temin did it for the right reasons and blamed the establishment of the interwar gold standard in a changed world in which the gold standard no longer functioned well and was an agent of deflation and depression.

There are several spots where the economics of the era are just briefly mentioned and not discussed much. There is no mention of the major debate of whether there was a bubble in stocks or not in the 1920s. This is far from clear from the literature — and my judgment is that it never will be decided. Alas, there is only one sentence mentioning that both Irving Fisher and John Maynard Keynes thought stock prices would continue to grow and both lost their fortunes. Moreover, there is no discussion of how deflation and the gold standard were linked. The recession of 1920-21 is blamed on deflation with no mention of this necessity for the re-establishment of a gold-backed currency at antebellum prices. But I do not wish to overstate the case. Payne does what he sets out to do and he is to be credited for such a readable book (indeed I read it twice!).

There is one matter, however, that cannot be unmentioned. I joined this club many years ago when James Hamilton showed me the error of my ways in a working paper I had sent him. It is a club to which Phillip Payne now belongs — and he should delight in being a part of this club as the membership list is long . . . and now we have one more. In four different places, he refers to “the Bank of the United States.” Well, it is really “the Bank of United States,” there is no “the” between “of” and “United.” Welcome to the club Professor Payne. And thanks for this very useful historical description of the bumpy road during the interwar period.

 
Randall Parker is editor of The Seminal Works of the Great Depression (Edward Elgar, 2011) and co-editor (with Robert Whaples) of The Handbook of Modern Economic History and The Handbook of Major Events in Economic History (both from Routledge, 2013).

Copyright (c) 2017 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (September 2017). All EH.Net reviews are archived at http://www.eh.net/BookReview.

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Macroeconomics and Fluctuations
Geographic Area(s):North America
Time Period(s):20th Century: Pre WWII

Currency Politics: The Political Economy of Exchange Rate Policy

Author(s):Frieden, Jeffry A.
Reviewer(s):Officer, Lawrence H.

Published by EH.Net (January 2015)

Jeffry A. Frieden, Currency Politics: The Political Economy of Exchange Rate Policy. Princeton, NJ: Princeton University Press, 2014. xi + 301 pp. $40 (cloth), ISBN: 978-0-691-16415-1.

Reviewed for EH.Net by Lawrence H. Officer, Department of Economics, University of Illinois at Chicago.

Jeffry A. Frieden, Professor of Government at Harvard University, has written a fine book on the determinants of decision-making regarding exchange-rate regime and, to some extent, exchange-rate level within the selected regime. The book is readable for both economists and political scientists. I recommend Currency Politics to both sets of scholars. Economists will learn about the political aspects of exchange-regime choice and political scientists about the economic aspects.

There are seven formal chapters, preceded by an introduction and followed by a brief concluding section. The references constitute a useful if selective body of literature, and the index is well-done. Chapter one, titled “The Political Economy of Currency Choice,” presents the author’s theory. Chapters two and three, dealing with the U.S. experience from 1862 to 1879, is the section of the book most relevant to economic historians. The exchange-regime controversies during the greenback and silver-controversy periods are well analyzed within the author’s theoretical framework. Attention is paid to contemporary views and to pertinent data, and innovative econometric investigations are included.

Chapters four (European Monetary Integration), five and six (Latin American experience) are empirical but not historical, as they deal with recent experience. Chapter seven (“The Politics of Exchange Rates: Implications and Extensions”) is bizarre, running breathlessly from case to case, even discussing China’s undervalued currency.

The author’s model involves exchange-rate regime determination by the relative political strengths of economic groups advantaged by exchange-rate stability (gold standard, euro, peg to dollar or deutschmark) and groups advantaged by exchange-rate flexibility and domestic currency depreciation. The former groups generally include the financial sector, producers of differentiated products (“specialized manufacturers”), and foreign-currency debtors; the latter, mainly tradables producers. Frieden warrants praise by economists for his uniform and careful attention to economic incentives as analytical support for his approach.

Very impressive is Frieden’s voting model to test the greenback-period economic groupings for “soft money” (against gold, currency contraction, and deflation) versus “hard money” (in favor of return to the former gold standard, and the contraction and deflation to make this possible). A voting model with Congressional (House) district as the unit has creative dependent and explanatory variables, based on Census data. For the 1860s, twenty-four votes involving the Contraction Act (or its suppression) and the redemption medium (gold or greenbacks) for government bonds, are incorporated. Results are consistent with the author’s theory: “Members of Congress specifically were more likely to vote for soft money if their constituency was less wealthy, and if more of their constituency’s economic activities were in import-sensitive manufacturing (i.e., in New England and Pennsylvania) or farming, especially of export crops” (pp. 95-96).

For the 1870s, a similar analysis involves six House bills, five of which failed to become law — but no matter. With a later Census, data are richer, and explanatory variables now include debt by Congressional district. This leads to an unexpected result, as districts with larger debt are in favor of gold! Frieden explains this anomaly by inferring that concern about nominal debt was not an important motivating force. Hmm!

The chapter on European monetary integration gives Frieden the opportunity to investigate the impact of domestic-price pass-through effects of exchange-rate change, an integral part of his model. Now the econometrics has countries as the basic unit, as is also the case for the Latin American experience.

The book is full of wise insights, some of which seem obvious. For example, “the more open an economy is, the more politically controversial its currency policy is likely to be” (p. 249). The author also notes the well-known flexibility of wages and prices in enhancing the classical gold standard. He makes the important point, not always emphasized, that the sustainability of the classical gold standard was founded on the consensus of elite groups internationally: countries must follow gold-standard rules, and rules should not be altered to fit the preferences of national governments — whence the U.S. deflationary policy during the greenback period, in order to return to the gold standard. As befitting a political scientist, Frieden notes the lack of democracy — hence the absence of political power of groups benefitting from currency depreciation — in fostering the stability of the gold standard. I wish that he had devoted more attention to this oft-neglected aspect of the gold standard.

I also wish that Frieden had applied his model — both theoretically and, data permitting, econometrically — to other cases of exchange-rate regime controversy, especially the various bullionist periods (in particular, English and Swedish). He says nothing about these experiences.

Without doubt, however, Frieden has set a high political-economic standard against which other interdisciplinary studies of exchange-rate regimes will have to measure themselves.

Lawrence H. Officer is Professor of Economics at University of Illinois at Chicago. His most recent books are Two Centuries of Compensation for U.S. Production Workers in Manufacturing and Everyday Economics: Honest Answers to Tough Questions, both published by Palgrave Macmillan.

Copyright (c) 2015 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (January 2015). All EH.Net reviews are archived at http://eh.net/book-reviews/

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):General, International, or Comparative
Europe
Latin America, incl. Mexico and the Caribbean
North America
Time Period(s):19th Century
20th Century: Pre WWII
20th Century: WWII and post-WWII

Financial Crises, 1929 to the Present

Author(s):Hsu, Sara
Reviewer(s):Wheelock, David C.

Published by EH.Net (November 2014)

Sara Hsu, Financial Crises, 1929 to the Present. Cheltenham, UK: Edward Elgar, 2013. v + 178 pp. $100 (cloth), ISBN: 978-0-85793-342-3.

Reviewed for EH.Net by David C. Wheelock, Federal Reserve Bank of St. Louis.

In Financial Crises, 1929 to the Present, Sara Hsu of the State University of New York, New Paltz, offers a concise history of several of the world’s major financial crises — from the Great Depression to the subprime mortgage crisis of 2007-08 and European debt crisis of 2009-10.

Financial crises are not easy to define precisely, except perhaps in the context of a stylized model, and different authors have used a variety of quantitative measures to identify and measure the severity of crises. In the first chapter of the book, Hsu explains how different authors define financial crises, focusing especially on the ideas of Hyman Minsky and Charles Kindleberger. Hsu provides neither a precise theoretical nor a quantitative definition of a financial crisis, but aligns herself with Minsky in concluding that unregulated financial systems of capitalist economies are inherently prone to instability and crises with potentially severe macroeconomic repercussions: “Hyman Minsky was right in the sense that given free rein, capitalism has created instability and unanticipated crises” (p. 146).

After a brief summary of how the global financial system has evolved since the 1930s, subsequent chapters review the histories of individual crises, beginning with the Great Depression. Hsu follows John Kenneth Galbraith in tracing the origins of the Great Depression to Wall Street speculation and attributes the eventual market crash to heightened uncertainty and a global credit crunch associated with French claims on British gold and the introduction of the Young Plan in 1929. Although she acknowledges the decline in the money stock and deflation that took hold after the crash, Hsu rejects the view of Friedman and Schwartz (1963) that banking panics and a contracting money supply caused the Great Depression, favoring instead Ben Bernanke’s (1983) emphasis on the nonmonetary effects that financial crises had on the economy.

The Great Depression led to major changes in the regulation of U.S. banks and financial markets, as well as disintegration of the international gold standard and the imposition of capital and exchange controls around the world. Controls became universal during World War II and remained in place for several years after the war under the post-war Bretton Woods system of fixed exchange rates. Hsu nicely summarizes key features of the Bretton Woods System and its breakdown in the 1970s in the book’s third chapter.
The remaining chapters summarize major financial crises, beginning with the debt crises of emerging market economies in the 1980s. Hsu explains how many emerging market economies had borrowed heavily to support economic growth when commodity prices were rising in the 1970s, only to experience difficulty servicing their debts and obtaining new loans when commodity prices fell after the Federal Reserve tightened monetary policy and the U.S. economy went into recession in the early 1980s. This chapter has an especially good summary of how the debt crisis unfolded in different countries and how lenders, governments, and the IMF responded.

Hsu next discusses several crises that occurred in the 1990s, including the Western European exchange rate crisis, Nordic banking crises, Japanese real estate collapse and subsequent “lost decade,” Mexican debt crisis, and Asian financial crisis. A subsequent chapter describes the Russian and Brazilian financial crises of 1998 and the Argentinian crisis of 2000. Like many others, Hsu is highly critical of the “conditionality” requirements imposed by the IMF on nations in crisis. For example, she argues that “The IMF program for Korea went beyond measures needed to resolve the crisis … and, destructively, called for even wider opening(!) of Korea’s capital and current accounts” (p. 91).

The penultimate chapter of the book focuses on the subprime mortgage crisis and recession of 2007-08, which originated in the United States but was felt around the world, and the European debt crisis that emerged in 2009-10. For Hsu, “the crisis showed that all financial markets are unstable and require constant supervision and regulation” (p. 129). She blames “excessive overleveraging” of subprime assets in the form of opaque financial instruments created by a largely unregulated and unsupervised banking system and the trading of those securities “over the counter” rather than through organized and regulated exchanges. She argues that much of the government’s response to the crisis, such as the Troubled Asset Relief Program, was flawed and failed to halt the crisis.

The final chapter considers alternative policies for preventing future crises and for containing and resolving any crises that might occur. Hsu is generally supportive of capital controls, macro-prudential bank regulations, and countercyclical fiscal and monetary policy, as well as greater coordination of policies across countries. Indeed, she argues that “The preeminence of country sovereignty and competitiveness over global financial stability ensures that fault lines will exist and expand, and that crises will continue to occur. Should country priorities shift en masse from economic growth to economic and financial stability, there is a much greater probability that future financial crises might be prevented” (p. 146).

The book could serve as a supplement for undergraduate courses in economic history, international finance, and macroeconomics or as a reference for anyone wishing summaries of the key events and issues surrounding particular crises. However, the book might hold less appeal for courses in U.S. economic history because it does not cover several noteworthy episodes of financial instability in the United States, such as the savings and loan crisis of the 1980s. Further, readers interested in more theoretical explanations of the causes and effects of financial crises or those interested in the interplay of political and economic forces that shape the financial regulatory environment and can promote instability and crises even in highly regulated financial systems, as discussed recently by Charles Calomiris and Stephen Haber (2014), will want to look elsewhere.

References:

Bernanke, Ben S. “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review 73(3), June 1983, pp. 257-76.

Calomiris, Charles W. and Stephen H. Haber. Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. Princeton: Princeton University Press, 2014.

Friedman, Milton and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton: Princeton University Press, 1963.

David C. Wheelock researches U.S. financial and monetary history. His recent publications include (with Michael D. Bordo), “The Promise and Performance of the Federal Reserve as Lender of Last Resort,” in M.D. Bordo and W. Roberds, editors, The Origins, History, and Future of the Federal Reserve: A Return to Jekyll Island. Cambridge University Press, 2013.

Copyright (c) 2014 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (November 2014). All EH.Net reviews are archived at http://www.eh.net/BookReview

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):General, International, or Comparative
Time Period(s):20th Century: Pre WWII
20th Century: WWII and post-WWII

The National Recovery Administration

Barbara Alexander, Charles River Associates

This article outlines the history of the National Recovery Administration, one of the most important and controversial agencies in Roosevelt’s New Deal. It discusses the agency’s “codes of fair competition” under which antitrust law exemptions could be granted in exchange for adoption of minimum wages, problems some industries encountered in their subsequent attempts to fix prices under the codes, and the macroeconomic effects of the program.

The early New Deal suspension of antitrust law under the National Recovery Administration (NRA) is surely one of the oddest episodes in American economic history. In its two-year life, the NRA oversaw the development of so-called “codes of fair competition” covering the larger part of the business landscape.1 The NRA generally is thought to have represented a political exchange whereby business gave up some of its rights over employees in exchange for permission to form cartels.2 Typically, labor is taken to have gotten the better part of the bargain; the union movement having extended its new powers after the Supreme Court abolished the NRA in 1935, while the business community faced a newly aggressive FTC by the end of the 1930s. While this characterization may be true in broad outline, close examination of the NRA reveals that matters may be somewhat more complicated than is suggested by the interpretation of the program as a win for labor contrasted with a missed opportunity for business.

Recent evaluations of the NRA have wended their way back to themes sounded during the early nineteen thirties, in particular, interrelationships between the so-called “trade practice” or cartelization provisions of the program and the grant of enhanced bargaining power to trade unions.3 On the microeconomic side, allowing unions to bargain for industry-wide wages may have facilitated cartelization in some industries. Meanwhile, macroeconomists have suggested that the Act and its progeny, especially labor measures such as the National Labor Relations Act may bear more responsibility for the length and severity of the Great Depression than has been recognized heretofore. 4 If this thesis holds up to closer scrutiny, the era may come to be seen as a primary example of the potential macroeconomic costs of shifts in political and economic power.

Kickoff Campaign and Blanket Codes

The NRA began operations in a burst of “ballyhoo” during the summer of 1933. 5 The agency was formed upon passage of the National Industrial Recovery Act (NIRA) in mid-June. A kick-off campaign of parades and press events succeeded in getting over 2 million employers to sign a preliminary “blanket code” known as the “President’s Re-Employment Agreement.” Signatories of the PRA pledged to pay minimum wages ranging from around $12 to $15 per 40-hour week, depending on size of town. Some 16 million workers were covered, out of a non-farm labor force of some 25 million. “Share-the-work” provisions called for limits of 35 to 40 hours per week for most employees. 6

NRA Codes

Over the next year and a half, the blanket code was superseded by over 500 codes negotiated for individual industries. The NIRA provided that: “Upon the application to the President by one or more trade or industrial associations or groups, the President may approve a code or codes of fair competition for the trade or industry.” 7 The carrot held out to induce participation was enticing: “any code … and any action complying with the provisions thereof . . . shall be exempt from the provisions of the antitrust laws of the United States.” 8 Representatives of trade associations overran Washington, and by the time the NRA was abolished, hundreds of codes covering over three-quarters of private, non-farm employment had been approved.9 Code signatories were supposed to be allowed to use the NRA “Blue Eagle” as a symbol that “we do our part” only as long as they remained in compliance with code provisions.10

Disputes Arise

Almost 80 percent of the codes had provisions that were directed at establishment of price floors.11 The Act did not specifically authorize businesses to fix prices, and indeed it specified that ” . . .codes are not designed to promote monopolies.” 12 However, it is an understatement to say that there was never any consensus among firms, industries and NRA officials as to precisely what was to be allowed as part of an acceptable code. Arguments about exactly what the NIRA allowed, and how the NRA should implement the Act began during its drafting and continued unabated throughout its life. The arguments extended from the level of general principles to the smallest details of policy, unsurprising given the complete dependence of appropriate regulatory design on precise regulatory objectives, which here were embroiled in dispute from start to finish.

To choose just one out of many examples of such disputes: There was a debate within the NRA as to whether “code authorities” (industry governing bodies) should be allowed to use industry-wide or “representative” cost data to define a price floor based on “lowest reasonable cost.” Most economists would understand this type of rule as a device that would facilitate monopoly pricing. However, a charitable interpretation of the views of administration proponents is that they had some sort of “soft competition” in mind. That is, they wished to develop and allow the use of mechanisms that would extend to more fragmented industries a type of peaceful coexistence more commonly associated with oligopoly. Those NRA supporters of the representative-cost-based price floor imagined that a range of prices would emerge if such a floor were to be set, whereas detractors believed that “the minimum would become the maximum,” that is, the floor would simply be a cartel price, constraining competition across all firms in an industry.13

Price Floors

While a rule allowing emergency price floors based on “lowest reasonable cost” was eventually approved, there was no coherent NRA program behind it.14 Indeed, the NRA and code authorities often operated at cross-purposes. At the same time that some officials of the NRA arguably took actions to promote softened competition, some in industry tried to implement measures more likely to support hard-core cartels, even when they thereby reduced the chance of soft competition should collusion fail. For example, with the partial support of the NRA, many code authorities moved to standardize products, shutting off product differentiation as an arena of potential rivalry, in spite of its role as one of the strongest mechanisms that might soften price competition.15 Of course if one is looking to run a naked price-fixing scheme, it is helpful to eliminate product differentiation as an avenue for cost-raising, profit-eroding rivalry. An industry push for standardization can thus be seen as a way of supporting hard-core cartelization, while less enthusiasm on the part of some administration officials may have reflected an understanding, however intuitive, that socially more desirable soft competition required that avenues for product differentiation be left open.

National Recovery Review Board

According to some critical observers then and later, the codes did lead to an unsurprising sort of “golden age” of cartelization. The National Recovery Review Board, led by an outraged Clarence Darrow (of Scopes “monkey trial” fame) concluded in May of 1934 that “in certain industries monopolistic practices existed.” 16 While there are legitimate examples of every variety of cartelization occurring under the NRA, many contemporaneous and subsequent assessments of Darrow’s work dismiss the Board’s “analysis” as hopelessly biased. Thus although its conclusions are interesting as a matter of political economy, it is far from clear that the Board carried out any dispassionate inventory of conditions across industries, much less a real weighing of evidence.17

Compliance Crisis

In contrast to Darrow’s perspective, other commentators focus on the “compliance crisis” that erupted within a few months of passage of the NIRA.18 Many industries were faced with “chiselers” who refused to respect code pricing rules. Firms that attempted to uphold code prices in the face of defection lost both market share and respect for the NRA.

NRA state compliance offices had recorded over 30,000 “trade practice” complaints by early 1935.19 However, the compliance program was characterized by “a marked timidity on the part of NRA enforcement officials.” 20 This timidity was fatal to the program, since monopoly pricing can easily be more damaging than is the most bare-knuckled competition to a firm that attempts it without parallel action from its competitors. NRA hesitancy came about as a result of doubts about whether a vigorous enforcement effort would withstand constitutional challenge, a not-unrelated lack of support from the Department of Justice, public antipathy for enforcement actions aimed at forcing sellers to charge higher prices, and unabating internal NRA disputes about the advisability of the price-fixing core of the trade practice program.21 Consequently, by mid-1934, firms disinclined to respect code pricing rules were ignoring them. By that point then, contrary to the initial expectations of many code signatories, the new antitrust regime represented only permission to form voluntary cartelization agreements, not the advent of government-enforced cartels. Even there, participants had to be discreet, so as not to run afoul of the antimonopoly language of the Act.

It is still far from clear how much market power was conferred by the NRA’s loosening of antitrust constraints. Of course, modern observers of the alternating successes and failures of cartels such as OPEC will not be surprised that the NRA program led to mixed results. In the absence of government enforcement, the program simply amounted to de facto legalization of self-enforcing cartels. With respect to the ease of collusion, economic theory is clear only on the point that self-enforceability is an open question; self-interest may lead to either breakdown of agreements or success at sustaining them.

Conflicts between Large and Small Firms

Some part of the difficulties encountered by NRA cartels may have had roots in a progressive mandate to offer special protection to the “little guy.” The NIRA had specified that acceptable codes of fair competition must not “eliminate or oppress small enterprises,” 22 and that “any organization availing itself of the benefits of this title shall be truly representative of the trade or industry . . . Any organization violating … shall cease to be entitled to the benefits of this title.” 23 Majority rule provisions were exceedingly common in codes, and were most likely a reflection of this statutory mandate. The concern for small enterprise had strong progressive roots.24 Justice Brandeis’s well-known antipathy for large-scale enterprise and concentration of economic power reflected a widespread and long-standing debate about the legitimate goals of the American experiment.

In addition to evaluating monopolization under the codes, the Darrow board had been charged with assessing the impact of the NRA on small business. Its conclusion was that “in certain industries small enterprises were oppressed.” Again however, as with his review of monopolization, Darrow may have seen only what he was predisposed to see. A number of NRA “code histories” detail conflicts within industries in which small, higher-cost producers sought to use majority rule provisions to support pricing at levels above those desired by larger, lower-cost producers. In the absence of effective enforcement from the government, such prices were doomed to break down, triggering repeated price wars in some industries.25

By 1935, there was understandable bitterness about what many businesses viewed as the lost promise of the NRA. Undoubtedly, the bitterness was exacerbated by the fact that the NRA wanted higher wages while failing to deliver the tools needed for effective cartelization. However, it is not entirely clear that everyone in the business community felt that the labor provisions of the Act were undesirable.26

Labor and Employment Issues

By their nature, market economies give rise to surplus-eroding rivalry among those who would be better off collectively if they could only act in concert. NRA codes of fair competition, specifying agreements on pricing and terms of employment, arose from a perceived confluence of interests among representatives of “business,” “labor,” and “the public” in muting that rivalry. Many proponents of the NIRA held that competitive pressures on business had led to downward pressure on wages, which in turn caused low consumption, leading to greater pressure on business, and so on. Allowing workers to organize and bargain collectively, while their employers pledged to one another not to sell below cost, was identified as a way to arrest harmful deflationary forces. Knowledge that one’s rivals would also be forced to pay “code wages” had some potential for aiding cartel survival. Thus the rationale for NRA wage supports at the microeconomic level potentially dovetailed with the macroeconomic theory by which higher wages were held to support higher consumption and, in turn, higher prices.

Labor provisions of the NIRA appeared in Section 7: “. . . employees shall have the right to organize and bargain collectively through representatives of their own choosing … employers shall comply with the maximum hours of labor, minimum rates of pay, and other conditions of employment…” 27 Each “code of fair competition” had to include labor provisions acceptable to the National Recovery Administration, developed during a process of negotiations, hearings, and review. Thus in order to obtain the shield against antitrust prosecution for their “trade practices” offered by an approved code, significant concessions to workers had to be made.

The NRA is generally judged to have been a success for labor and a miserable failure for business. However, evaluation is complicated to the extent that labor could not have achieved gains with respect to collective bargaining rights over wages and working conditions, had those rights not been more or less willingly granted by employers operating under the belief that stabilization of labor costs would facilitate cartelization. The labor provisions may have indeed helped some industries as well as helping workers, and for firms in such industries, the NRA cannot have been judged a failure. Moreover, while some businesses may have found the Act beneficial, because labor cost stability or freedom to negotiate with rivals enhanced their ability to cooperate on price, it is not entirely obvious that workers as a class gained as much as is sometimes contended.

The NRA did help solidify new and important norms regarding child labor, maximum hours, and other conditions of employment; it will never be known if the same progress could have been made had not industry been more or less hornswoggled into giving ground, using the antitrust laws as bait. Whatever the long-term effects of the NRA on worker welfare, the short-term gains for labor associated with higher wages were questionable. While those workers who managed to stay employed throughout the nineteen thirties benefited from higher wages, to the extent that workers were also consumers, and often unemployed consumers at that, or even potential entrepreneurs, they may have been better off without the NRA.

The issue is far from settled. Ben Bernanke and Martin Parkinson examine the economic growth that occurred during the New Deal in spite of higher wages and suggest “part of the answer may be that the higher wages ‘paid for themselves’ through increased productivity of labor. Probably more important, though, is the observation that with imperfectly competitive product markets, output depends on aggregate demand as well as the real wage. Maybe Herbert Hoover and Henry Ford were right: Higher real wages may have paid for themselves in the broader sense that their positive effect on aggregate demand compensated for their tendency to raise cost.” 28 However, Christina Romer establishes a close connection between NRA programs and the failure of wages and prices to adjust to high unemployment levels. In her view, “By preventing the large negative deviations of output from trend in the mid-1930s from exerting deflationary pressure, [the NRA] prevented the economy’s self-correction mechanism from working.” 29

Aftermath of Supreme Court’s Ruling in Schecter Case

The Supreme Court struck down the NRA on May 27, 1935; the case was a dispute over violations of labor provisions of the “Live Poultry Code” allegedly perpetrated by the Schecter Poultry Corporation. The Court held the code to be invalid on grounds of “attempted delegation of legislative power and the attempted regulation of intrastate transactions which affect interstate commerce only indirectly.” 30 There were to be no more grand bargains between business and labor under the New Deal.

Riven by divergent agendas rooted in industry- and firm-specific technology and demand, “business” was never able to speak with even the tenuous degree of unity achieved by workers. Following the abortive attempt to get the government to enforce cartels, firms and industries went their own ways, using a variety of strategies to enhance their situations. A number of sectors did succeed in getting passage of “little NRAs” with mechanisms tailored to mute competition in their particular circumstances. These mechanisms included the Robinson-Patman Act, aimed at strengthening traditional retailers against the ability of chain stores to buy at lower prices, the Guffey Acts, in which high cost bituminous coal operators and coal miners sought protection from the competition of lower cost operators, and the Motor Carrier Act in which high cost incumbent truckers obtained protection against new entrants.31

On-going macroeconomic analysis suggests that the general public interest may have been poorly served by the experiment of the NRA. Like many macroeconomic theories, the validity of the underconsumption scenario that was put forth in support of the program depended on the strength and timing of the operation of its various mechanisms. Increasingly it appears that the NRA set off inflationary forces thought by some to be desirable at the time, but that in fact had depressing effects on demand for labor and on output. Pure monopolistic deadweight losses probably were less important than higher wage costs (although there has not been any close examination of inefficiencies that may have resulted from the NRA’s attempt to protect small higher-cost producers). The strength of any mitigating effects on aggregate demand remains to be established.

1 Leverett Lyon, P. Homan, L. Lorwin, G. Terborgh, C. Dearing, L. Marshall, The National Recovery Administration: An Analysis and Appraisal, Washington: Brooking Institution, 1935, p. 313, footnote 9.

2 See, for example, Charles Frederick Roos, NRA Economic Planning, Colorado Springs: Cowles Commission, 1935, p. 343.

3See, for example, Colin Gordon, New Deals: Business, Labor, and Politics in America, 1920-1935, New York: Cambridge University Press, 1993, especially chapter 5.

4Christina D. Romer, “Why Did Prices Rise in the 1930s?” Journal of Economic History 59, no. 1 (1999): 167-199; Michael Weinstein, Recovery and Redistribution under the NIRA, Amsterdam: North Holland, 1980, and Harold L. Cole and Lee E. Ohanian, “New Deal Policies and the Persistence of the Great Depression,” Working Paper 597, Federal Reserve Bank of Minneapolis, February 2001. But also see “Unemployment, Inflation and Wages in the American Depression: Are There Lessons for Europe?” Ben Bernanke and Martin Parkinson, American Economic Review: Papers and Proceedings 79, no. 2 (1989): 210-214.

5 See, for example, Donald Brand, Corporatism and the Rule of Law: A Study of the National Recovery Administration, Ithaca: Cornell University Press, 1988, p. 94.

6 See, for example, Roos, op. cit., pp. 77, 92.

7 Section 3(a) of The National Industrial Recovery Act, reprinted at p. 478 of Roos, op. Cit.

8 Section 5 of The National Industrial Recovery Act, reprinted at p. 483 of Roos, op. cit. Note though, that the legal status of actions taken during the NRA era was never clear; Roos points out that “…President Roosevelt signed an executive order on January 20, 1934, providing that any complainant of monopolistic practices … could press it before the Federal Trade Commission or request the assistance of the Department of Justice. And, on the same date, Donald Richberg issued a supplementary statement which said that the provisions of the anti-trust laws were still in effect and that the NRA would not tolerate monopolistic practices.” (Roos, op. cit. p. 376.)

9 Lyon, op. cit., p. 307, cited at p. 52 in Lee and Ohanian, op cit.

10 Roos, op. cit., p. 75; and Blackwell Smith, My Imprint on the Sands of Time: The Life of a New Dealer, Vantage Press, New York, p. 109.

11 Lyon, op. cit., p. 570.

12 Section 3 (a)(2) of The National Industrial Recovery Act, op. Cit.

13 Roos, op. cit., at pp. 254-259. Charles Roos comments that “Leon Henderson and Blackwell Smith, in particular, became intrigued with a notion that competition could be set up within limits and that in this way wide price variations tending to demoralize an industry could be prevented.”

14 Lyon, et al., op. cit., p. 605.

15 Smith, Assistant Counsel of the NRA (per Roos, op cit., p. 254), has the following to say about standardization: One of the more controversial subjects, which we didn’t get into too deeply, except to draw guidelines, was standardization.” Smith goes on to discuss the obvious need to standardize rail track gauges, plumbing fittings, and the like, but concludes, “Industry on the whole wanted more standardization than we could go with.” (Blackwell Smith, op. cit., pp. 106-7.) One must not go overboard looking for coherence among the various positions espoused by NRA administrators; along these lines it is worth remembering Smith’s statement some 60 years later: “Business’s reaction to my policy [Smith was speaking generally here of his collective proposals] to some extent was hostile. They wished that the codes were not as strict as I wanted them to be. Also, there was criticism from the liberal/labor side to the effect that the codes were more in favor of business than they should have been. I said, ‘We are guided by a squealometer. We tune policy until the squeals are the same pitch from both sides.'” (Smith, op. cit. p. 108.)

16 Quoted at p 378 of Roos, op. Cit.

17 Brand, op. cit. at pp. 159-60 cites in agreement extremely critical conclusions by Roos (op. cit. at p. 409) and Arthur Schlesinger, The Age of Roosevelt: The Coming of the New Deal, Boston: Houghton Mifflin, 1959, p. 133.

18 Roos acknowledges a breakdown by spring of 1934: “By March, 1934 something was urgently needed to encourage industry to observe code provisions; business support for the NRA had decreased materially and serious compliance difficulties had arisen.” (Roos, op. cit., at p. 318.) Brand dates the start of the compliance crisis much earlier, in the fall of 1933. (Brand, op. cit., p. 103.)

19 Lyon, op. cit., p. 264.

20 Lyon, op. cit., p. 268.

21 Lyon, op. cit., pp. 268-272. See also Peter H. Irons, The New Deal Lawyers, Princeton: Princeton University Press, 1982.

22 Section 3(a)(2) of The National Industrial Recovery Act, op. Cit.

23 Section 6(b) of The National Industrial Recovery Act, op. Cit.

24 Brand, op. Cit.

25 Barbara Alexander and Gary D. Libecap, “The Effect of Cost Heterogeneity in the Success and Failure of the New Deal’s Agricultural and Industrial Programs,” Explorations in Economic History, 37 (2000), pp. 370-400.

26 Gordon, op. Cit.

27 Section 7 of the National Industrial Recovery Act, reprinted at pp. 484-5 of Roos, op. Cit.

28 Bernanke and Parkinson, op. cit., p. 214.

29 Romer, op. cit., p. 197.

30 Supreme Court of the United States, Nos. 854 and 864, October term, 1934, (decision issued May 27, 1935). Reprinted in Roos, op. cit., p. 580.

31 Ellis W. Hawley, The New Deal and the Problem of Monopoly: A Study in Economic Ambivalence, 1966, Princeton: Princeton University Press, p. 249; Irons, op. cit., pp. 105-106, 248.

Citation: Alexander, Barbara. “National Recovery Administration”. EH.Net Encyclopedia, edited by Robert Whaples. August 14, 2001. URL http://eh.net/encyclopedia/the-national-recovery-administration/

Turnpikes and Toll Roads in Nineteenth-Century America

Daniel B. Klein, Santa Clara University and John Majewski, University of California – Santa Barbara 1

Private turnpikes were business corporations that built and maintained a road for the right to collect fees from travelers.2 Accounts of the nineteenth-century transportation revolution often treat turnpikes as merely a prelude to more important improvements such as canals and railroads. Turnpikes, however, left important social and political imprints on the communities that debated and supported them. Although turnpikes rarely paid dividends or other forms of direct profit, they nevertheless attracted enough capital to expand both the coverage and quality of the U. S. road system. Turnpikes demonstrated how nineteenth-century Americans integrated elements of the modern corporation – with its emphasis on profit-taking residual claimants – with non-pecuniary motivations such as use and esteem.

Private road building came and went in waves throughout the nineteenth century and across the country, with between 2,500 and 3,200 companies successfully financing, building, and operating their toll road. There were three especially important episodes of toll road construction: the turnpike era of the eastern states 1792 to 1845; the plank road boom 1847 to 1853; and the toll road of the far West 1850 to 1902.

The Turnpike Era, 1792–1845

Prior to the 1790s Americans had no direct experience with private turnpikes; roads were built, financed and managed mainly by town governments. Typically, townships compelled a road labor tax. The State of New York, for example, assessed eligible males a minimum of three days of roadwork under penalty of fine of one dollar. The labor requirement could be avoided if the worker paid a fee of 62.5 cents a day. As with public works of any kind, incentives were weak because the chain of activity could not be traced to a residual claimant – that is, private owners who claim the “residuals,” profit or loss. The laborers were brought together in a transitory, disconnected manner. Since overseers and laborers were commonly farmers, too often the crop schedule, rather than road deterioration, dictated the repairs schedule. Except in cases of special appropriations, financing came in dribbles deriving mostly from the fines and commutations of the assessed inhabitants. Commissioners could hardly lay plans for decisive improvements. When a needed connection passed through unsettled lands, it was especially difficult to mobilize labor because assessments could be worked out only in the district in which the laborer resided. Because work areas were divided into districts, as well as into towns, problems arose coordinating the various jurisdictions. Road conditions thus remained inadequate, as New York’s governors often acknowledged publicly (Klein and Majewski 1992, 472-75).

For Americans looking for better connections to markets, the poor state of the road system was a major problem. In 1790, a viable steamboat had not yet been built, canal construction was hard to finance and limited in scope, and the first American railroad would not be completed for another forty years. Better transportation meant, above all, better highways. State and local governments, however, had small bureaucracies and limited budgets which prevented a substantial public sector response. Turnpikes, in essence, were organizational innovations borne out of necessity – “the states admitted that they were unequal to the task and enlisted the aid of private enterprise” (Durrenberger 1931, 37).

America’s very limited and lackluster experience with the publicly operated toll roads of the 1780s hardly portended a future boom in private toll roads, but the success of private toll bridges may have inspired some future turnpike companies. From 1786 to 1798, fifty-nine private toll bridge companies were chartered in the northeast, beginning with Boston’s Charles River Bridge, which brought investors an average annual return of 10.5 percent in its first six years (Davis 1917, II, 188). Private toll bridges operated without many of the regulations that would hamper the private toll roads that soon followed, such as mandatory toll exemptions and conflicts over the location of toll gates. Also, toll bridges, by their very nature, faced little toll evasion, which was a serious problem for toll roads.

The more significant predecessor to America’s private toll road movement was Britain’s success with private toll roads. Beginning in 1663 and peaking from 1750 to 1772, Britain experienced a private turnpike movement large enough to acquire the nickname “turnpike mania” (Pawson 1977, 151). Although the British movement inspired the future American turnpike movement, the institutional differences between the two were substantial. Most important, perhaps, was the difference in their organizational forms. British turnpikes were incorporated as trusts – non-profit organizations financed by bonds – while American turnpikes were stock-financed corporations seemingly organized to pay dividends, though acting within narrow limits determined by the charter. Contrary to modern sensibilities, this difference made the British trusts, which operated under the firm expectation of fulfilling bond obligations, more intent and more successful in garnering residuals. In contrast, for the American turnpikes the hope of dividends was merely a faint hope, and never a legal obligation. Odd as it sounds, the stock-financed “business” corporation was better suited to operating the project as a civic enterprise, paying out returns in use and esteem rather than cash.

The first private turnpike in the United States was chartered by Pennsylvania in 1792 and opened two years later. Spanning 62 miles between Philadelphia and Lancaster, it quickly attracted the attention of merchants in other states, who recognized its potential to direct commerce away from their regions. Soon lawmakers from those states began chartering turnpikes. By 1800, 69 turnpike companies had been chartered throughout the country, especially in Connecticut (23) and New York (13). Over the next decade nearly six times as many turnpikes were incorporated (398). Table 1 shows that in the mid-Atlantic and New England states between 1800 and 1830, turnpike companies accounted for 27 percent of all business incorporations.

Table 1: Turnpikes as a Percentage of All Business Incorporations,
by Special and General Acts, 1800-1830

As shown in Table 2, a wider set of states had incorporated 1562 turnpikes by the end of 1845. Somewhere between 50 to 70 percent of these succeeded in building and operating toll roads. A variety of regulatory and economic conditions – outlined below – account for why a relatively low percentage of chartered turnpikes became going concerns. In New York, for example, tolls could be collected only after turnpikes passed inspections, which were typically conducted after ten miles of roadway had been built. Only 35 to 40 percent of New York turnpike projects – or about 165 companies – reached operational status. In Connecticut, by contrast, where settlement covered the state and turnpikes more often took over existing roadbeds, construction costs were much lower and about 87 percent of the companies reached operation (Taylor 1934, 210).

Table 2: Turnpike Incorporation, 1792-1845

State 1792-1800 1801-10 1811-20 1821-30 1831-40 1841-45 Total
NH 4 45 5 1 4 0 59
VT 9 19 15 7 4 3 57
MA 9 80 8 16 1 1 115
RI 3 13 8 13 3 1 41
CT 23 37 16 24 13 0 113
NY 13 126 133 75 83 27 457
PA 5 39 101 59 101 37 342
NJ 0 22 22 3 3 0 50
VA 0 6 7 8 25 0 46
MD 3 9 33 12 14 7 78
OH 0 2 14 12 114 62 204
Total 69 398 362 230 365 138 1562

Source: Klein and Fielding 1992: 325.

Although the states of Pennsylvania, Virginia and Ohio subsidized privately-operated turnpike companies, most turnpikes were financed solely by private stock subscription and structured to pay dividends. This was a significant achievement, considering the large construction costs (averaging around $1,500 to $2,000 per mile) and the typical length (15 to 40 miles). But the achievement was most striking because, as New England historian Edward Kirkland (1948, 45) put it, “the turnpikes did not make money. As a whole this was true; as a rule it was clear from the beginning.” Organizers and “investors” generally regarded the initial proceeds from sale of stock as a fund from which to build the facility, which would then earn enough in toll receipts to cover operating expenses. One might hope for dividend payments as well, but “it seems to have been generally known long before the rush of construction subsided that turnpike stock was worthless” (Wood 1919, 63).3

Turnpikes promised little in the way of direct dividends and profits, but they offered potentially large indirect benefits. Because turnpikes facilitated movement and trade, nearby merchants, farmers, land owners, and ordinary residents would benefit from a turnpike. Gazetteer Thomas F. Gordon aptly summarized the relationship between these “indirect benefits” and investment in turnpikes: “None have yielded profitable returns to the stockholders, but everyone feels that he has been repaid for his expenditures in the improved value of his lands, and the economy of business” (quoted in Majewski 2000, 49). Gordon’s statement raises an important question. If one could not be excluded from benefiting from a turnpike, and if dividends were not in the offing, what incentive would anyone have to help finance turnpike construction? The turnpike communities faced a serious free-rider problem.

Nevertheless, hundreds of communities overcame the free-rider problem, mostly through a civic-minded culture that encouraged investment for long-term community gain. Alexis de Tocqueville observed that, excepting those of the South, Americans were infused with a spirit of public-mindedness. Their strong sense of community spirit resulted in the funding of schools, libraries, hospitals, churches, canals, dredging companies, wharves, and water companies, as well as turnpikes (Goodrich 1948). Vibrant community and cooperation sprung, according to Tocqueville, from the fertile ground of liberty:

If it is a question of taking a road past his property, [a man] sees at once that this small public matter has a bearing on his greatest private interests, and there is no need to point out to him the close connection between his private profit and the general interest. … Local liberties, then, which induce a great number of citizens to value the affection of their kindred and neighbors, bring men constantly into contact, despite the instincts which separate them, and force them to help one another. … The free institutions of the United States and the political rights enjoyed there provide a thousand continual reminders to every citizen that he lives in society. … Having no particular reason to hate others, since he is neither their slave nor their master, the American’s heart easily inclines toward benevolence. At first it is of necessity that men attend to the public interest, afterward by choice. What had been calculation becomes instinct. By dint of working for the good of his fellow citizens, he in the end acquires a habit and taste for serving them. … I maintain that there is only one effective remedy against the evils which equality may cause, and that is political liberty (Alexis de Tocqueville, 511-13, Lawrence/Mayer edition).

Tocqueville’s testimonial is broad and general, but its accuracy is seen in the archival records and local histories of the turnpike communities. Stockholder’s lists reveal a web of neighbors, kin, and locally prominent figures voluntarily contributing to what they saw as an important community improvement. Appeals made in newspapers, local speeches, town meetings, door-to-door solicitations, correspondence, and negotiations in assembling the route stressed the importance of community improvement rather than dividends.4 Furthermore, many toll road projects involved the effort to build a monument and symbol of the community. Participating in a company by donating cash or giving moral support was a relatively rewarding way of establishing public services; it was pursued at least in part for the sake of community romance and adventure as ends in themselves (Brown 1973, 68). It should be noted that turnpikes were not entirely exceptional enterprises in the early nineteenth century. In many fields, the corporate form had a public-service ethos, aimed not primarily at paying dividends, but at serving the community (Handlin and Handlin 1945, 22, Goodrich 1948, 306, Hurst 1970, 15).

Given the importance of community activism and long-term gains, most “investors” tended to be not outside speculators, but locals positioned to enjoy the turnpikes’ indirect benefits. “But with a few exceptions, the vast majority of the stockholders in turnpike were farmers, land speculators, merchants or individuals and firms interested in commerce” (Durrenberger 1931, 104). A large number of ordinary households held turnpike stock. Pennsylvania compiled the most complete set of investment records, which show that more than 24,000 individuals purchased turnpike or toll bridge stock between 1800 and 1821. The average holding was $250 worth of stock, and the median was less than $150 (Majewski 2001). Such sums indicate that most turnpike investors were wealthier than the average citizen, but hardly part of the urban elite that dominated larger corporations such as the Bank of the United States. County-level studies indicate that most turnpike investment came from farmers and artisans, as opposed to the merchants and professionals more usually associated with early corporations (Majewski 2000, 49-53).

Turnpikes became symbols of civic pride only after enduring a period of substantial controversy. In the 1790s and early 1800s, some Americans feared that turnpikes would become “engrossing monopolists” who would charge travelers exorbitant tolls or abuse eminent domain privileges. Others simply did not want to pay for travel that had formerly been free. To conciliate these different groups, legislators wrote numerous restrictions into turnpike charters. Toll gates, for example, often could be spaced no closer than every five or even ten miles. This regulation enabled some users to travel without encountering a toll gate, and eased the practice of steering horses and the high-mounted vehicles of the day off the main road so as to evade the toll gate, a practice known as “shunpiking.” The charters or general laws also granted numerous exemptions from toll payment. In New York, the exempt included people traveling on family business, those attending or returning from church services and funerals, town meetings, blacksmiths’ shops, those on military duty, and those who lived within one mile of a toll gate. In Massachusetts some of the same trips were exempt and also anyone residing in the town where the gate is placed and anyone “on the common and ordinary business of family concerns” (Laws of Massachusetts 1805, chapter 79, 649). In the face of exemptions and shunpiking, turnpike operators sometimes petitioned authorities for a toll hike, stiffer penalties against shunpikers, or the relocating of the toll gate. The record indicates that petitioning the legislature for such relief was a costly and uncertain affair (Klein and Majewski 1992, 496-98).

In view of the difficult regulatory environment and apparent free-rider problem, the success of early turnpikes in raising money and improving roads was striking. The movement built new roads at rates previously unheard of in America. Table 3 gives ballpark estimates of the cumulative investment in constructing turnpikes up to 1830 in New England and the Middle Atlantic. Repair and maintenance costs are excluded. These construction investment figures are probably too low – they generally exclude, for example, tolls revenue that might have been used to finish construction – but they nevertheless indicate the ability of private initiatives to raise money in an economy in which capital was in short supply. Turnpike companies in these states raised more than $24 million by 1830, an amount equaling 6.15 percent of those states’ 1830 GDP. To put this into comparative perspective, between 1956 and 1995 all levels of government spent $330 billion (in 1996 dollars) in building the interstate highway system, a cumulative total equaling only 4.30 percent of 1996 GDP.

Table 3
Cumulative Turnpike Investment (1800-1830) as percentage of 1830 GNP

State Cumulative Turnpike Investment, 1800-1830 ($) Cumulative Turnpike Investment as Percent of 1830 GDP Cumulative Turnpike Investment per Capita, 1830 ($)
Maine 35,000 0.16 0.09
New Hampshire 575,100 2.11 2.14
Vermont 484,000 3.37 1.72
Massachusetts 4,200,000 7.41 6.88
Rhode Island 140,000 1.54 1.44
Connecticut 1,036,160 4.68 3.48
New Jersey 1,100,000 4.79 3.43
New York 9,000,000 7.06 4.69
Pennsylvania 6,400,000 6.67 4.75
Maryland 1,500,000 3.85 3.36
TOTAL 24,470,260 6.15 4.49
Interstate Highway System, 1956-1996 330 Billion 4.15 (1996 GNP)

Sources: Pennsylvania turnpike investment: Durrenberger 1931: 61); New England turnpike investment: Taylor 1934: 210-11; New York, New Jersey, and Maryland turnpike investment: Fishlow 2000, 549. Only private investment is included. State GDP data come from Bodenhorn 2000: 237. Figures for the cost of the Interstate Highway System can be found at http://www.publicpurpose.com/hwy-is$.htm. Please note that our investment figures generally do not include investment to finish roads by loans or the use of toll revenue. The table therefore underestimates investment in turnpikes.

The organizational advantages of turnpike companies relative to government road not only generated more road mileage, but also higher quality roads (Taylor 1934, 334, Parks 1967, 23, 27). New York state gazetteer Horatio Spafford (1824, 125) wrote that turnpikes have been “an excellent school, in every road district, and people now work the highways to much better advantage than formerly.” Companies worked to intelligently develop roadway to achieve connective communication. The corporate form traversed town and county boundaries, so a single company could bring what would otherwise be separate segments together into a single organization. “Merchants and traders in New York sponsored pikes leading across northern New Jersey in order to tap the Delaware Valley trade which would otherwise have gone to Philadelphia” (Lane 1939, 156).

Turnpike networks became highly organized systems that sought to find the most efficient way of connecting eastern cities with western markets. Decades before the Erie Canal, private individuals realized the natural opening through the Appalachians and planned a system of turnpikes connecting Albany to Syracuse and beyond. Figure 1 shows the principal routes westward from Albany. The upper route begins with the Albany & Schenectady Turnpike, connects to the Mohawk Turnpike, and then the Seneca Turnpike. The lower route begins with the First Great Western Turnpike and then branches at Cherry Valley into the Second and Third Great Western Turnpikes. Corporate papers of these companies reveal that organizers of different companies talked to each other; they were quite capable of coordinating their intentions and planning mutually beneficial activities by voluntary means. When the Erie Canal was completed in 1825 it roughly followed the alignment of the upper route and greatly reduced travel on the competing turnpikes (Baer, Klein, and Majewski 1992).

Figure 1: Turnpike Network in Central New York, 1845
detail

Another excellent example of turnpike integration was the Pittsburgh Pike. The Pennsylvania route consisted of a combination of five turnpike companies, each of which built a road segment connecting Pittsburgh and Harrisburg, where travelers could take another series of turnpikes to Philadelphia. Completed in 1820, the Pittsburgh Pike greatly improved freighting over the rugged Allegheny Mountains. Freight rates between Philadelphia and Pittsburgh were cut in half because wagons increased their capacity, speed, and certainty (Reiser 1951, 76-77). Although the state government invested in the companies that formed the Pittsburgh Pike, records of the two companies for which we have complete investment information shows that private interests contributed 62 percent of the capital (calculated from Majewski 2000: 47-51: Reiser 1951, 76). Residents in numerous communities contributed to individual projects out of their own self interest. Their provincialism nevertheless helped create a coherent and integrated system.

A comparison of the Pittsburgh Pike and the National Road demonstrated the advantages of turnpike corporations over roads financed directly from government sources. Financed by the federal government, the National Road was built between Cumberland, Maryland, and Wheeling, West Virginia, where it was then extended through the Midwest with the hopes of reaching the Mississippi River. Although it never reached the Mississippi, the Federal Government nevertheless spent $6.8 million on the project (Goodrich 1960, 54, 65). The trans-Appalachian section of the National Road competed directly against the Pittsburgh Pike. From the records of two of the five companies that formed the Pittsburgh Pike, we estimate it cost $4,805 per mile to build (Majewski 2000, 47-51, Reiser 1951, 76). The Federal government, on the other hand, spent $13,455 per mile to complete the first 200 miles of the National Road (Fishlow 2000, 549). Besides costing much less, the Pennsylvania Pike was far better in quality. The toll gates along the Pittsburgh Pike provided a steady stream of revenue for repairs. The National Road, on the other hand, depended upon intermittent government outlays for basic maintenance, and the road quickly deteriorated. One army engineer in 1832 found “the road in a shocking condition, and every rod of it will require great repair; some of it now is almost impassable” (quoted in Searight, 60). Historians have found that travelers generally preferred to take the Pittsburgh Pike rather than the National Road.

The Plank Road Boom, 1847–1853

By the 1840s the major turnpikes were increasingly eclipsed by the (often state-subsidized) canals and railroads. Many toll roads reverted to free public use and quickly degenerated into miles of dust, mud and wheel-carved ruts. To link to the new and more powerful modes of communication, well-maintained, short-distance highways were still needed, but because governments became overextended in poor investments in canals, taxpayers were increasingly reluctant to fund internal improvements. Private entrepreneurs found the cost of the technologically most attractive road surfacing material (macadam, a compacted covering of crushed stones) prohibitively expensive at $3,500 per mile. Thus the ongoing need for new feeder roads spurred the search for innovation, and plank roads – toll roads surfaced with wooden planks – seemed to fit the need.

The plank road technique appears to have been introduced into Canada from Russia in 1840. It reached New York a few years later, after the village Salina, near Syracuse, sent civil engineer George Geddes to Toronto to investigate. After two trips Geddes (whose father, James, was an engineer for the Erie and Champlain Canals, and an enthusiastic canal advocate) was convinced of the plank roads’ feasibility and became their great booster. Plank roads, he wrote in Scientific American (Geddes 1850a), could be built at an average cost of $1,500 – although $1,900 would have been more accurate (Majewski, Baer and Klein 1994, 109, fn15). Geddes also published a pamphlet containing an influential, if overly optimistic, estimate that Toronto’s road planks had lasted eight years (Geddes 1850b). Simplicity of design made plank roads even more attractive. Road builders put down two parallel lines of timbers four or five feet apart, which formed the “foundation” of the road. They then laid, at right angles, planks that were about eight feet long and three or four inches thick. Builders used no nails or glue to secure the planks – they were secured only by their own weight – but they did build ditches on each side of the road to insure proper drainage (Klein and Majewski 1994, 42-43).

No less important than plank road economics and technology were the public policy changes that accompanied plank roads. Policymakers, perhaps aware that overly restrictive charters had hamstrung the first turnpike movement, were more permissive in the plank road era. Adjusting for deflation, toll rates were higher, toll gates were separated by shorter distances, and fewer local travelers were exempted from payment of tolls.

Although few today have heard of them, for a short time it seemed that plank roads might be one of the great innovations of the day. In just a few years, more than 1,000 companies built more than 10,000 miles of plank roads nationwide, including more than 3,500 miles in New York (Klein and Majewski 1994, Majewski, Baer, Klein 1993). According to one observer, plank roads, along with canals and railroads, were “the three great inscriptions graven on the earth by the hand of modern science, never to be obliterated, but to grow deeper and deeper” (Bogart 1851).

Except for most of New England, plank roads were chartered throughout the United States, especially in the top lumber-producing states of the Midwest and Mid-Atlantic states, as shown in Table 4.

Table 4: Plank Road Incorporation by State

State Number
New York 335
Pennsylvania 315
Ohio 205
Wisconsin 130
Michigan 122
Illinois 88
North Carolina 54
Missouri 49
New Jersey 25
Georgia 16
Iowa 14
Vermont 14
Maryland 13
Connecticut 7
Massachusetts 1
Rhode Island, Maine 0
Total 1388

Notes: The figure for Ohio is through 1851; Pennsylvania, New Jersey, and Maryland are through 1857. Few plank roads were incorporated after 1857. In western states, some roads were incorporated and built as plank roads, so the 1388 total is not to be taken as a total for the nation. For a complete description of the sources for this table, see Majewski, Baer, & Klein 1993: 110.

New York, the leading lumber state, had both the greatest number of plank road charters (350) and the largest value of lumber production ($13,126,000 in 1849 dollars). Plank roads were especially popular in rural dairy counties, where farmers needed quick and dependable transportation to urban markets (Majewski, Baer and Klein 1993).

The plank road and eastern turnpike episodes shared several features in common. Like the earlier turnpikes, investment in plank road companies came from local landowners, farmers, merchants, and professionals. Stock purchases were motivated less by the prospect of earning dividends than by the convenience and increased trade and development that the roads would bring. To many communities, plank roads held the hope of revitalization and the reversal (or slowing) of relative decline. But those hoping to attain these benefits once again were faced with a free-rider problem. Investors in plank roads, like the investors of the earlier turnpikes, were motivated often by esteem mechanisms – community allegiance and appreciation, reputational incentives, and their own conscience.

Although plank roads were smooth and sturdy, faring better in rain and snow than did dirt and gravel roads, they lasted only four or five years – not the eight to twelve years that promoters had claimed. Thus, the rush of construction ended suddenly by 1853, and by 1865 most companies had either switched to dirt and gravel surfaces or abandoned their road altogether.

Toll Roads in the Far West, 1850 to 1902

Unlike the areas served by the earlier turnpikes and plank roads, Colorado, Nevada, and California in the 1850s and 1860s lacked the settled communities and social networks that induced participation in community enterprise and improvement. Miners and the merchants who served them knew that the mining boom would not continue indefinitely and therefore seldom planted deep roots. Nor were the large farms that later populated California ripe for civic engagement in anywhere near the degree of the small farms of the east. Society in the early years of the West was not one where town meetings, door-to-door solicitations, and newspaper campaigns were likely to rally broad support for a road project. The lack of strong communities also meant that there would be few opponents to pressure the government for toll exemptions and otherwise hamper toll road operations. These conditions ensured that toll roads would tend to be more profit-oriented than the eastern turnpikes and plank road companies. Still, it is not clear whether on the whole the toll roads of the Far West were profitable.

The California toll road era began in 1850 after passage of general laws of incorporation. In 1853 new laws were passed reducing stock subscription requirements from $2,000 per mile to $300 per mile. The 1853 laws also delegated regulatory authority to the county governments. Counties were allowed “to set tolls at rates not to prevent a return of 20 percent,” but they did not interfere with the location of toll roads and usually looked favorably on the toll road companies. After passage of the 1853 laws, the number of toll road incorporations increased dramatically, peaking to nearly 40 new incorporations in 1866 alone. Companies were also created by special acts of the legislature. And sometimes they seemed to have operated without formal incorporation at all. David and Linda Beito (1998, 75, 84) show that in Nevada many entrepreneurs had built and operated toll roads – or other basic infrastructure – before there was a State of Nevada, and some operated for years without any government authority at all.

All told, in the Golden State, approximately 414 toll road companies were initiated,5 resulting in at least 159 companies that successfully built and operated toll roads. Table 5 provides some rough numbers for toll roads in western states. The numbers presented there are minimums. For California and Nevada, the numbers probably only slightly underestimate the true totals; for the other states the figures are quite sketchy and might significantly underestimate true totals. Again, an abundance of testimony indicates that the private road companies were the serious road builders, in terms of quantity and quality (see the ten quotations at Klein and Yin 1996, 689-90).

Table 5: Rough Minimums on Toll Roads in the West

Toll Road
Incorporations
Toll Roads
actually built
California 414 159
Colorado 350 n.a.
Nevada n.a. 117
Texas 50 n.a.
Wyoming 11 n.a.
Oregon 10 n.a.

Sources: For California, Klein and Yin 1996: 681-82; for Nevada, Beito and Beito 1998: 74; for the other states, notes and correspondence in D. Klein’s files.

Table 6 makes an attempt to justify guesses about total number of toll road companies and total toll road miles. The first three numbers in the “Incorporations” column come from Tables 2, 4, and 5. The estimates of success rates and average road length (in the third and fourth columns) are extrapolations from components that have been studied with more care. We have made these estimates conservative, in the sense of avoiding any overstatement of the extent of private road building. The ~ symbol has been used to keep the reader mindful of the fact that many of these numbers are estimates. The numbers in the right hand column have been rounded to the nearest 1000, so as to avoid any impression of accuracy. The “Other” row throws in a line to suggest a minimum to cover all the regions, periods, and road types not covered in Tables 2, 4, and 5. For example, the “Other” row would cover turnpikes in the East, South and Midwest after 1845 (Virginia’s turnpike boom came in the late 1840s and 1850s), and all turnpikes and plank roads in Indiana, whose county-based incorporation, it seems, has never been systematically researched. Ideally, not only would the numbers be more definite and complete, but there would be a weighting by years of operation. The “30,000 – 52,000 miles” should be read as a range for the sum of all the miles operated by any company at any time during the 100+ year period.

Table 6: A Rough Tally of the Private Toll Roads

Toll Road Movements Incorporations % Successful in Building Road Roads Built and Operated Average Road Length Toll Road

Miles Operated

Turnpikes incorporated from 1792 to 1845 1562 ~ 55 % ~ 859 ~ 18 ~ 15,000
Plank Roads incorporated from 1845 to roughly 1860 1388 ~ 65 % ~ 902 ~ 10 ~ 9,000
Toll Roads in the West incorporated from 1850 to roughly 1902 ~ 1127 ~ 40 % ~ 450 ~ 15 ~ 7,000
Other ~ <1000>

[a rough guess]

~ 50 % ~ 500 ~ 16 ~ 8,000
Ranges for

Totals

5,000 – 5,600

incorporations

48 – 60 percent 2,500 – 3,200 roads 12 – 16 miles 30,000 – 52,000

miles

Sources: Those of Tables 2, 4, and 5, plus the research files of the authors.

The End of Toll Roads in the Progressive Period

In 1880 many toll road companies nationwide continued to operate – probably in the range of 400 to 600 companies.6 But by 1920 the private toll road was almost entirely stamped out. From Maine to California, the laws and political attitudes from around 1880 onward moved against the handling of social affairs in ways that seemed informal, inexpert and unsystematic. Progressivism represented a burgeoning of more collectivist ideologies and policy reforms. Many progressive intellectuals took inspiration from European socialist doctrines. Although the politics of restraining corporate evils had a democratic and populist aspect, the bureaucratic spirit was highly managerial and hierarchical, intending to replicate the efficiency of large corporations in the new professional and scientific administration of government (Higgs 1987, 113-116, Ekirch 1967, 171-94).

One might point to the rise of the bicycle and later the automobile, which needed a harder and smoother surface, to explain the growth of America’s road network in the Progressive period. But such demand-side changes do not speak to the issues of road ownership and tolling. Automobiles achieved higher speeds, which made stopping to pay a toll more inconvenient, and that may have reinforced the anti-toll-road company movement that was underway prior to the automobile. Such developments figured into the history of road policy, but they really did not provide a good reason for the policy movement against the toll roads The following words of a county board of supervisors in New York in 1906 indicate a more general ideological bent against toll road companies:

[T]he ownership and operation of this road by a private corporation is contrary to public sentiment in this county, and [the] cause of good roads, which has received so much attention in this state in recent years, requires that this antiquated system should be abolished. … That public opinion throughout the state is strongly in favor of the abolition of toll roads is indicated by the fact that since the passage of the act of 1899, which permits counties to acquire these roads, the boards of supervisors of most of the counties where such roads have existed have availed themselves of its provisions and practically abolished the toll road.

Given such attitudes, it was no wonder that within the U. S. Department of Agricultural, the new Office of Road Inquiry began in 1893 to gather information, conduct research, and “educate” for better roads. The new bureaucracy opposed toll roads, and the Federal Highway Act of 1916 barred the use of tolls on highways receiving federal money (Seely 1987, 15, 79). Anti-toll-road sentiment became state and national policy.

Conclusions and Implications

Throughout the nineteenth-century, the United States was notoriously “land-rich” and “capital poor.” The viability of turnpikes shows how Americans devised institutions – in this case, toll-collecting corporations – that allowed them to invest precious capital in important public projects. What’s more, turnpikes paid little in direct dividends and stock appreciation, yet still attracted investment. Investors, of course, cared for long-term economic development, but that does not account for how turnpike organizers overcame the important public goods problem of buying turnpike stock. Esteem, social pressure, and other non-economic motivations influenced local residents to make investments that they knew would be unprofitable (at least in a direct sense) but would nevertheless help the entire community. On the other hand, the turnpike companies enjoyed the organizational clarity of stock ownership and residual returns. All companies faced the possibility of pressure from investors, who might have wanted to salvage something of their investment. Residual claimancy may have enhanced the viability of many projects, including communitarian projects undertaken primarily for use and esteem.

The combining of these two ingredients – the appeal of use and esteem, and the incentives and proprietary clarity of residual returns – is today severely undermined by the modern legal bifurcation of private initiative into “not-for-profit” and “for-profit” concerns. Not-for-profit corporations can appeal to use and esteem but cannot organize themselves to earn residual returns. For-profit corporations organize themselves for residual returns but cannot very well appeal to use and esteem. As already noted, prior to modern tax law and regulation, the old American toll roads were, relative to the British turnpike trusts, more, not less, use-and-esteem oriented by virtue of being structured to pay dividends rather than interest. Like the eighteenth century British turnpike trusts, the twentieth century American governmental toll projects financed (in part) by privately purchased bonds generally failed, relative to the nineteenth century American company model, to draw on use and esteem motivations.

The turnpike experience of nineteenth-century America suggests that the stock/dividend company can also be a fruitful, efficient, and socially beneficial way to make losses and go on making losses. The success of turnpikes suggests that our modern sensibility of dividing enterprises between profit and non-profit – a distinction embedded in modern tax laws and regulations – unnecessarily impoverishes the imagination of economists and other policy makers. Without such strict legal and institutional bifurcation, our own modern society might better recognize the esteem in trade and the trade in esteem.

References

Baer, Christopher T., Daniel B. Klein, and John Majewski. “From Trunk to Branch: Toll Roads in New York, 1800-1860.” Essays in Economic and Business History XI (1993): 191-209.

Beito, David T., and Linda Royster Beito. “Rival Road Builders: Private Toll Roads in Nevada, 1852-1880.” Nevada Historical Society Quarterly 41 (1998): 71- 91.

Benson, Bruce. “Are Public Goods Really Common Pools? Consideration of the Evolution of Policing and Highways in England.” Economic Inquiry 32 no. 2 (1994).

Bogart, W. H. “First Plank Road.” Hunt’s Merchant Magazine (1851).

Brown, Richard D. “The Emergence of Voluntary Associations in Massachusetts, 1760-1830.” Journal of Voluntary Action Research (1973): 64-73.

Bodenhorn, Howard. A History of Banking in Antebellum America. New York: Cambridge University Press, 2000.

Cage, R. A. “The Lowden Empire: A Case Study of Wagon Roads in Northern California.” The Pacific Historian 28 (1984): 33-48.

Davis, Joseph S. Essays in the Earlier History of American Corporations. Cambridge: Harvard University Press, 1917.

DuBasky, Mayo. The Gist of Mencken: Quotations from America’s Critic. Metuchen, NJ: Scarecrow Press, 1990.

Durrenberger, J.A. Turnpikes: A Study of the Toll Road Movement in the Middle Atlantic States and Maryland. Valdosta, GA.: Southern Stationery and Printing, 1981.

Ekirch, Arthur A., Jr. The Decline of American Liberalism. New York: Atheneum, 1967.

Fishlow, Albert. “Internal Transportation in the Nineteenth and Early Twentieth Centuries.” In The Cambridge Economic History of the United States, Vol. II: The Long Nineteenth Century, edited by Stanley L. Engerman and Robert E. Gallman. New York: Cambridge University Press, 2000.

Geddes, George. Scientific American 5 (April 27, 1850).

Geddes, George. Observations upon Plank Roads. Syracuse: L.W. Hall, 1850.

Goodrich, Carter. “Public Spirit and American Improvements.” Proceedings of the American Philosophical Society, 92 (1948): 305-09.

Goodrich, Carter. Government Promotion of American Canals and Railroads, 1800-1890. New York: Columbia University Press, 1960.

Gunderson, Gerald. “Privatization and the Nineteenth-Century Turnpike.” Cato Journal 9 no. 1 (1989): 191-200.

Higgs, Robert. Crises and Leviathan: Critical Episodes in the Growth of American Government. New York: Oxford University Press, 1987.

Higgs, Robert. “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War.” Independent Review 1 no. 4 (1997): 561-600.

Kaplan, Michael D. “The Toll Road Building Career of Otto Mears, 1881-1887.” Colorado Magazine 52 (1975): 153-70.

Kirkland, Edward C. Men, Cities and Transportation: A Study in New England History, 1820-1900. Cambridge, MA.: Harvard University Press, 1948.

Klein, Daniel. “The Voluntary Provision of Public Goods? The Turnpike Companies of Early America.” Economic Inquiry (1990): 788-812. (Reprinted in The Voluntary City, edited by David Beito, Peter Gordon and Alexander Tabarrok. Ann Arbor: University of Michigan Press, 2002.)

Klein, Daniel B. and Gordon J. Fielding. “Private Toll Roads: Learning from the Nineteenth Century.” Transportation Quarterly 46, no. 3 (1992): 321-41.

Klein, Daniel B. and John Majewski. “Economy, Community and Law: The Turnpike Movement in New York, 1797-1845.” Law & Society Review 26, no. 3 (1992): 469-512.

Klein, Daniel B. and John Majewski. “Plank Road Fever in Antebellum America: New York State Origins.” New York History (1994): 39-65.

Klein, Daniel B. and Chi Yin. “Use, Esteem, and Profit in Voluntary Provision: Toll Roads in California, 1850-1902.” Economic Inquiry (1996): 678-92.

Kresge, David T. and Paul O. Roberts. Techniques of Transport Planning, Volume Two: Systems Analysis and Simulation Models. Washington DC: Brookings Institution, 1971.

Lane, Wheaton J. From Indian Trail to Iron Horse: Travel and Transportation in New Jersey, 1620-1860. Princeton: Princeton University Press, 1939.

Majewski, John. A House Dividing: Economic Development in Pennsylvania and Virginia before the Civil War. New York: Cambridge University Press, 2000.

Majewski, John. “The Booster Spirit and ‘Mid-Atlantic’ Distinctiveness: Shareholding in Pennsylvania Banking and Transportation Corporations, 1800 to 1840.” Manuscript, Department of History, UC Santa Barbara, 2001.

Majewski, John, Christopher Baer and Daniel B. Klein. “Responding to Relative Decline: The Plank Road Boom of Antebellum New York.” Journal of Economic History 53, no. 1 (1993): 106-122.

Nash, Christopher A. “Integration of Public Transport: An Economic Assessment.” In Bus Deregulation and Privatisation: An International Perspective, edited by J.S. Dodgson and N. Topham. Brookfield, VT: Avebury, 1988

Nash, Gerald D. State Government and Economic Development: A History of Administrative Policies in California, 1849-1933. Berkeley: University of California Press (Institute of Governmental Studies), 1964.

Pawson, Eric. Transport and Economy: The Turnpike Roads of Eighteenth Century Britain. London: Academic Press, 1977.

Peyton, Billy Joe. “Survey and Building the [National] Road.” In The National Road, edited by Karl Raitz. Baltimore: Johns Hopkins University Press, 1996.

Poole, Robert W. “Private Toll Roads.” In Privatizing Transportation Systems, edited by Simon Hakim, Paul Seidenstate, and Gary W. Bowman. Westport, CT: Praeger, 1996

Reiser, Catherine Elizabeth. Pittsburgh’s Commercial Development, 1800-1850. Harrisburg: Pennsylvania Historical and Museum Commission, 1951.

Ridgway, Arthur. “The Mission of Colorado Toll Roads.” Colorado Magazine 9 (1932): 161-169.

Roth, Gabriel. Roads in a Market Economy. Aldershot, England: Avebury Technical, 1996.

Searight, Thomas B. The Old Pike: A History of the National Road. Uniontown, PA: Thomas Searight, 1894.

Seely, Bruce E. Building the American Highway System: Engineers as Policy Makers. Philadelphia: Temple University Press, 1987.

Taylor, George R. The Transportation Revolution, 1815-1860. New York: Rinehart, 1951

Thwaites, Reuben Gold. Early Western Travels, 1746-1846. Cleveland: A. H. Clark, 1907.

U. S. Agency for International Development. “A History of Foreign Assistance.” On the U.S. A.I.D. Website. Posted April 3, 2002. Accessed January 20, 2003.

Wood, Frederick J. The Turnpikes of New England and Evolution of the Same through England, Virginia, and Maryland. Boston: Marshall Jones, 1919.

1 Daniel Klein, Department of Economics, Santa Clara University, Santa Clara, CA, 95053, and Ratio Institute, Stockholm, Sweden; Email: Dklein@scu.edu.

John Majewski, Department of History, University of California, Santa Barbara, 93106; Email: Majewski@history.ucsb.edu.

2 The term “turnpike” comes from Britain, referring to a long staff (or pike) that acted as a swinging barrier or tollgate. In nineteenth century America, “turnpike” specifically means a toll road with a surface of gravel and earth, as opposed to “plank roads” which refer to toll roads surfaced by wooden planks. Later in the century, all such roads were typically just “toll roads.”

3 For a discussion of returns and expectations, see Klein 1990: 791-95.

4 See Klein 1990: 803-808, Klein and Majewski 1994: 56-61.

5 The 414 figure consists of 222 companies organized under the general law, 102 charted by the legislature, and 90 companies that we learned of by county records, local histories, and various other sources.

6 Durrenberger (1931: 164) notes that in 1911 there were 108 turnpikes operating in Pennsylvania alone.

Citation: Klein, Daniel and John Majewski. “Turnpikes and Toll Roads in Nineteenth-Century America”. EH.Net Encyclopedia, edited by Robert Whaples. February 10, 2008. URL http://eh.net/encyclopedia/turnpikes-and-toll-roads-in-nineteenth-century-america/

The 1929 Stock Market Crash

Harold Bierman, Jr., Cornell University

Overview

The 1929 stock market crash is conventionally said to have occurred on Thursday the 24th and Tuesday the 29th of October. These two dates have been dubbed “Black Thursday” and “Black Tuesday,” respectively. On September 3, 1929, the Dow Jones Industrial Average reached a record high of 381.2. At the end of the market day on Thursday, October 24, the market was at 299.5 — a 21 percent decline from the high. On this day the market fell 33 points — a drop of 9 percent — on trading that was approximately three times the normal daily volume for the first nine months of the year. By all accounts, there was a selling panic. By November 13, 1929, the market had fallen to 199. By the time the crash was completed in 1932, following an unprecedentedly large economic depression, stocks had lost nearly 90 percent of their value.

The events of Black Thursday are normally defined to be the start of the stock market crash of 1929-1932, but the series of events leading to the crash started before that date. This article examines the causes of the 1929 stock market crash. While no consensus exists about its precise causes, the article will critique some arguments and support a preferred set of conclusions. It argues that one of the primary causes was the attempt by important people and the media to stop market speculators. A second probable cause was the great expansion of investment trusts, public utility holding companies, and the amount of margin buying, all of which fueled the purchase of public utility stocks, and drove up their prices. Public utilities, utility holding companies, and investment trusts were all highly levered using large amounts of debt and preferred stock. These factors seem to have set the stage for the triggering event. This sector was vulnerable to the arrival of bad news regarding utility regulation. In October 1929, the bad news arrived and utility stocks fell dramatically. After the utilities decreased in price, margin buyers had to sell and there was then panic selling of all stocks.

The Conventional View

The crash helped bring on the depression of the thirties and the depression helped to extend the period of low stock prices, thus “proving” to many that the prices had been too high.

Laying the blame for the “boom” on speculators was common in 1929. Thus, immediately upon learning of the crash of October 24 John Maynard Keynes (Moggridge, 1981, p. 2 of Vol. XX) wrote in the New York Evening Post (25 October 1929) that “The extraordinary speculation on Wall Street in past months has driven up the rate of interest to an unprecedented level.” And the Economist when stock prices reached their low for the year repeated the theme that the U.S. stock market had been too high (November 2, 1929, p. 806): “there is warrant for hoping that the deflation of the exaggerated balloon of American stock values will be for the good of the world.” The key phrases in these quotations are “exaggerated balloon of American stock values” and “extraordinary speculation on Wall Street.” Likewise, President Herbert Hoover saw increasing stock market prices leading up to the crash as a speculative bubble manufactured by the mistakes of the Federal Reserve Board. “One of these clouds was an American wave of optimism, born of continued progress over the decade, which the Federal Reserve Board transformed into the stock-exchange Mississippi Bubble” (Hoover, 1952). Thus, the common viewpoint was that stock prices were too high.

There is much to criticize in conventional interpretations of the 1929 stock market crash, however. (Even the name is inexact. The largest losses to the market did not come in October 1929 but rather in the following two years.) In December 1929, many expert economists, including Keynes and Irving Fisher, felt that the financial crisis had ended and by April 1930 the Standard and Poor 500 composite index was at 25.92, compared to a 1929 close of 21.45. There are good reasons for thinking that the stock market was not obviously overvalued in 1929 and that it was sensible to hold most stocks in the fall of 1929 and to buy stocks in December 1929 (admittedly this investment strategy would have been terribly unsuccessful).

Were Stocks Obviously Overpriced in October 1929?
Debatable — Economic Indicators Were Strong

From 1925 to the third quarter of 1929, common stocks increased in value by 120 percent in four years, a compound annual growth of 21.8%. While this is a large rate of appreciation, it is not obvious proof of an “orgy of speculation.” The decade of the 1920s was extremely prosperous and the stock market with its rising prices reflected this prosperity as well as the expectation that the prosperity would continue.

The fact that the stock market lost 90 percent of its value from 1929 to 1932 indicates that the market, at least using one criterion (actual performance of the market), was overvalued in 1929. John Kenneth Galbraith (1961) implies that there was a speculative orgy and that the crash was predictable: “Early in 1928, the nature of the boom changed. The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.” Galbraith had no difficulty in 1961 identifying the end of the boom in 1929: “On the first of January of 1929, as a matter of probability, it was most likely that the boom would end before the year was out.”

Compare this position with the fact that Irving Fisher, one of the leading economists in the U.S. at the time, was heavily invested in stocks and was bullish before and after the October sell offs; he lost his entire wealth (including his house) before stocks started to recover. In England, John Maynard Keynes, possibly the world’s leading economist during the first half of the twentieth century, and an acknowledged master of practical finance, also lost heavily. Paul Samuelson (1979) quotes P. Sergeant Florence (another leading economist): “Keynes may have made his own fortune and that of King’s College, but the investment trust of Keynes and Dennis Robertson managed to lose my fortune in 1929.”

Galbraith’s ability to ‘forecast’ the market turn is not shared by all. Samuelson (1979) admits that: “playing as I often do the experiment of studying price profiles with their dates concealed, I discovered that I would have been caught by the 1929 debacle.” For many, the collapse from 1929 to 1933 was neither foreseeable nor inevitable.

The stock price increases leading to October 1929, were not driven solely by fools or speculators. There were also intelligent, knowledgeable investors who were buying or holding stocks in September and October 1929. Also, leading economists, both then and now, could neither anticipate nor explain the October 1929 decline of the market. Thus, the conviction that stocks were obviously overpriced is somewhat of a myth.

The nation’s total real income rose from 1921 to 1923 by 10.5% per year, and from 1923 to 1929, it rose 3.4% per year. The 1920s were, in fact, a period of real growth and prosperity. For the period of 1923-1929, wholesale prices went down 0.9% per year, reflecting moderate stable growth in the money supply during a period of healthy real growth.

Examining the manufacturing situation in the United States prior to the crash is also informative. Irving Fisher’s Stock Market Crash and After (1930) offers much data indicating that there was real growth in the manufacturing sector. The evidence presented goes a long way to explain Fisher’s optimism regarding the level of stock prices. What Fisher saw was manufacturing efficiency rapidly increasing (output per worker) as was manufacturing output and the use of electricity.

The financial fundamentals of the markets were also strong. During 1928, the price-earnings ratio for 45 industrial stocks increased from approximately 12 to approximately 14. It was over 15 in 1929 for industrials and then decreased to approximately 10 by the end of 1929. While not low, these price-earnings (P/E) ratios were by no means out of line historically. Values in this range would be considered reasonable by most market analysts today. For example, the P/E ratio of the S & P 500 in July 2003 reached a high of 33 and in May 2004 the high was 23.

The rise in stock prices was not uniform across all industries. The stocks that went up the most were in industries where the economic fundamentals indicated there was cause for large amounts of optimism. They included airplanes, agricultural implements, chemicals, department stores, steel, utilities, telephone and telegraph, electrical equipment, oil, paper, and radio. These were reasonable choices for expectations of growth.

To put the P/E ratios of 10 to 15 in perspective, note that government bonds in 1929 yielded 3.4%. Industrial bonds of investment grade were yielding 5.1%. Consider that an interest rate of 5.1% represents a 1/(0.051) = 19.6 price-earnings ratio for debt.

In 1930, the Federal Reserve Bulletin reported production in 1920 at an index of 87.1 The index went down to 67 in 1921, then climbed steadily (except for 1924) until it reached 125 in 1929. This is an annual growth rate in production of 3.1%. During the period commodity prices actually decreased. The production record for the ten-year period was exceptionally good.

Factory payrolls in September were at an index of 111 (an all-time high). In October the index dropped to 110, which beat all previous months and years except for September 1929. The factory employment measures were consistent with the payroll index.

The September unadjusted measure of freight car loadings was at 121 — also an all-time record.2 In October the loadings dropped to 118, which was a performance second only to September’s record measure.

J.W. Kendrick (1961) shows that the period 1919-1929 had an unusually high rate of change in total factor productivity. The annual rate of change of 5.3% for 1919-1929 for the manufacturing sector was more than twice the 2.5% rate of the second best period (1948-1953). Farming productivity change for 1919-1929 was second only to the period 1929-1937. Overall, the period 1919-1929 easily took first place for productivity increases, handily beating the six other time periods studied by Kendrick (all the periods studies were prior to 1961) with an annual productivity change measure of 3.7%. This was outstanding economic performance — performance which normally would justify stock market optimism.

In the first nine months of 1929, 1,436 firms announced increased dividends. In 1928, the number was only 955 and in 1927, it was 755. In September 1929 dividend increased were announced by 193 firms compared with 135 the year before. The financial news from corporations was very positive in September and October 1929.

The May issue of the National City Bank of New York Newsletter indicated the earnings statements for the first quarter of surveyed firms showed a 31% increase compared to the first quarter of 1928. The August issue showed that for 650 firms the increase for the first six months of 1929 compared to 1928 was 24.4%. In September, the results were expanded to 916 firms with a 27.4% increase. The earnings for the third quarter for 638 firms were calculated to be 14.1% larger than for 1928. This is evidence that the general level of business activity and reported profits were excellent at the end of September 1929 and the middle of October 1929.

Barrie Wigmore (1985) researched 1929 financial data for 135 firms. The market price as a percentage of year-end book value was 420% using the high prices and 181% using the low prices. However, the return on equity for the firms (using the year-end book value) was a high 16.5%. The dividend yield was 2.96% using the high stock prices and 5.9% using the low stock prices.

Article after article from January to October in business magazines carried news of outstanding economic performance. E.K. Berger and A.M. Leinbach, two staff writers of the Magazine of Wall Street, wrote in June 1929: “Business so far this year has astonished even the perennial optimists.”

To summarize: There was little hint of a severe weakness in the real economy in the months prior to October 1929. There is a great deal of evidence that in 1929 stock prices were not out of line with the real economics of the firms that had issued the stock. Leading economists were betting that common stocks in the fall of 1929 were a good buy. Conventional financial reports of corporations gave cause for optimism relative to the 1929 earnings of corporations. Price-earnings ratios, dividend amounts and changes in dividends, and earnings and changes in earnings all gave cause for stock price optimism.

Table 1 shows the average of the highs and lows of the Dow Jones Industrial Index for 1922 to 1932.

Table 1
Dow-Jones Industrials Index Average
of Lows and Highs for the Year
1922 91.0
1923 95.6
1924 104.4
1925 137.2
1926 150.9
1927 177.6
1928 245.6
1929 290.0
1930 225.8
1931 134.1
1932 79.4

Sources: 1922-1929 measures are from the Stock Market Study, U.S. Senate, 1955, pp. 40, 49, 110, and 111; 1930-1932 Wigmore, 1985, pp. 637-639.

Using the information of Table 1, from 1922 to 1929 stocks rose in value by 218.7%. This is equivalent to an 18% annual growth rate in value for the seven years. From 1929 to 1932 stocks lost 73% of their value (different indices measured at different time would give different measures of the increase and decrease). The price increases were large, but not beyond comprehension. The price decreases taken to 1932 were consistent with the fact that by 1932 there was a worldwide depression.

If we take the 386 high of September 1929 and the 1929-year end value of 248.5, the market lost 36% of its value during that four-month period. Most of us, if we held stock in September 1929 would not have sold early in October. In fact, if I had money to invest, I would have purchased after the major break on Black Thursday, October 24. (I would have been sorry.)

Events Precipitating the Crash

Although it can be argued that the stock market was not overvalued, there is evidence that many feared that it was overvalued — including the Federal Reserve Board and the United States Senate. By 1929, there were many who felt the market price of equity securities had increased too much, and this feeling was reinforced daily by the media and statements by influential government officials.

What precipitated the October 1929 crash?

My research minimizes several candidates that are frequently cited by others (see Bierman 1991, 1998, 1999, and 2001).

  • The market did not fall just because it was too high — as argued above it is not obvious that it was too high.
  • The actions of the Federal Reserve, while not always wise, cannot be directly identified with the October stock market crashes in an important way.
  • The Smoot-Hawley tariff, while looming on the horizon, was not cited by the news sources in 1929 as a factor, and was probably not important to the October 1929 market.
  • The Hatry Affair in England was not material for the New York Stock Exchange and the timing did not coincide with the October crashes.
  • Business activity news in October was generally good and there were very few hints of a coming depression.
  • Short selling and bear raids were not large enough to move the entire market.
  • Fraud and other illegal or immoral acts were not material, despite the attention they have received.

Barsky and DeLong (1990, p. 280) stress the importance of fundamentals rather than fads or fashions. “Our conclusion is that major decade-to-decade stock market movements arise predominantly from careful re-evaluation of fundamentals and less so from fads or fashions.” The argument below is consistent with their conclusion, but there will be one major exception. In September 1929, the market value of one segment of the market, the public utility sector, should be based on existing fundamentals, and fundamentals seem to have changed considerably in October 1929.

A Look at the Financial Press

Thursday, October 3, 1929, the Washington Post with a page 1 headline exclaimed “Stock Prices Crash in Frantic Selling.” the New York Times of October 4 headed a page 1 article with “Year’s Worst Break Hits Stock Market.” The article on the first page of the Times cited three contributing factors:

  • A large broker loan increase was expected (the article stated that the loans increased, but the increase was not as large as expected).
  • The statement by Philip Snowden, England’s Chancellor of the Exchequer that described America’s stock market as a “speculative orgy.”
  • Weakening of margin accounts making it necessary to sell, which further depressed prices.

While the 1928 and 1929 financial press focused extensively and excessively on broker loans and margin account activity, the statement by Snowden is the only unique relevant news event on October 3. The October 4 (p. 20) issue of the Wall Street Journal also reported the remark by Snowden that there was “a perfect orgy of speculation.” Also, on October 4, the New York Times made another editorial reference to Snowden’s American speculation orgy. It added that “Wall Street had come to recognize its truth.” The editorial also quoted Secretary of the Treasury Mellon that investors “acted as if the price of securities would infinitely advance.” The Times editor obviously thought there was excessive speculation, and agreed with Snowden.

The stock market went down on October 3 and October 4, but almost all reported business news was very optimistic. The primary negative news item was the statement by Snowden regarding the amount of speculation in the American stock market. The market had been subjected to a barrage of statements throughout the year that there was excessive speculation and that the level of stock prices was too high. There is a possibility that the Snowden comment reported on October 3 was the push that started the boulder down the hill, but there were other events that also jeopardized the level of the market.

On August 8, the Federal Reserve Bank of New York had increased the rediscount rate from 5 to 6%. On September 26 the Bank of England raised its discount rate from 5.5 to 6.5%. England was losing gold as a result of investment in the New York Stock Exchange and wanted to decrease this investment. The Hatry Case also happened in September. It was first reported on September 29, 1929. Both the collapse of the Hatry industrial empire and the increase in the investment returns available in England resulted in shrinkage of English investment (especially the financing of broker loans) in the United States, adding to the market instability in the beginning of October.

Wednesday, October 16, 1929

On Wednesday, October 16, stock prices again declined. the Washington Post (October 17, p. 1) reported “Crushing Blow Again Dealt Stock Market.” Remember, the start of the stock market crash is conventionally identified with Black Thursday, October 24, but there were price declines on October 3, 4, and 16.

The news reports of the Post on October 17 and subsequent days are important since they were Associated Press (AP) releases, thus broadly read throughout the country. The Associated Press reported (p. 1) “The index of 20 leading public utilities computed for the Associated Press by the Standard Statistics Co. dropped 19.7 points to 302.4 which contrasts with the year’s high established less than a month ago.” This index had also dropped 18.7 points on October 3 and 4.3 points on October 4. The Times (October 17, p. 38) reported, “The utility stocks suffered most as a group in the day’s break.”

The economic news after the price drops of October 3 and October 4 had been good. But the deluge of bad news regarding public utility regulation seems to have truly upset the market. On Saturday, October 19, the Washington Post headlined (p. 13) “20 Utility Stocks Hit New Low Mark” and (Associated Press) “The utility shares again broke wide open and the general list came tumbling down almost half as far.” The October 20 issue of the Post had another relevant AP article (p. 12) “The selling again concentrated today on the utilities, which were in general depressed to the lowest levels since early July.”

An evaluation of the October 16 break in the New York Times on Sunday, October 20 (pp. 1 and 29) gave the following favorable factors:

  • stable business condition
  • low money rates (5%)
  • good retail trade
  • revival of the bond market
  • buying power of investment trusts
  • largest short interest in history (this is the total dollar value of stock sold where the investors do not own the stock they sold)

The following negative factors were described:

  • undigested investment trusts and new common stock shares
  • increase in broker loans
  • some high stock prices
  • agricultural prices lower
  • nervous market

The negative factors were not very upsetting to an investor if one was optimistic that the real economic boom (business prosperity) would continue. The Times failed to consider the impact on the market of the news concerning the regulation of public utilities.

Monday, October 21, 1929

On Monday, October 21, the market went down again. The Times (October 22) identified the causes to be

  • margin sellers (buyers on margin being forced to sell)
  • foreign money liquidating
  • skillful short selling

The same newspaper carried an article about a talk by Irving Fisher (p. 24) “Fisher says prices of stocks are low.” Fisher also defended investment trusts as offering investors diversification, thus reduced risk. He was reminded by a person attending the talk that in May he had “pointed out that predicting the human behavior of the market was quite different from analyzing its economic soundness.” Fisher was better with fundamentals than market psychology.

Wednesday, October 23, 1929

On Wednesday, October 23 the market tumbled. The Times headlines (October 24, p.1) said “Prices of Stocks Crash in Heavy Liquidation.” The Washington Post (p. 1) had “Huge Selling Wave Creates Near-Panic as Stocks Collapse.” In a total market value of $87 billion the market declined $4 billion — a 4.6% drop. If the events of the next day (Black Thursday) had not occurred, October 23 would have gone down in history as a major stock market event. But October 24 was to make the “Crash” of October 23 become merely a “Dip.”

The Times lamented October 24, (p. 38) “There was hardly a single item of news which might be construed as bearish.”

Thursday, October 24, 1929

Thursday, October 24 (Black Thursday) was a 12,894,650 share day (the previous record was 8,246,742 shares on March 26, 1929) on the NYSE. The headline on page one of the Times (October 25) was “Treasury Officials Blame Speculation.”

The Times (p. 41) moaned that the cost of call money had been 20% in March and the price break in March was understandable. (A call loan is a loan payable on demand of the lender.) Call money on October 24 cost only 5%. There should not have been a crash. The Friday Wall Street Journal (October 25) gave New York bankers credit for stopping the price decline with $1 billion of support.

the Washington Post (October 26, p. 1) reported “Market Drop Fails to Alarm Officials.” The “officials” were all in Washington. The rest of the country seemed alarmed. On October 25, the market gained. President Hoover made a statement on Friday regarding the excellent state of business, but then added how building and construction had been adversely “affected by the high interest rates induced by stock speculation” (New York Times, October 26, p. 1). A Times editorial (p. 16) quoted Snowden’s “orgy of speculation” again.

Tuesday, October 29, 1929

The Sunday, October 27 edition of the Times had a two-column article “Bay State Utilities Face Investigation.” It implied that regulation in Massachusetts was going to be less friendly towards utilities. Stocks again went down on Monday, October 28. There were 9,212,800 shares traded (3,000,000 in the final hour). The Times on Tuesday, October 29 again carried an article on the New York public utility investigating committee being critical of the rate making process. October 29 was “Black Tuesday.” The headline the next day was “Stocks Collapse in 16,410,030 Share Day” (October 30, p. 1). Stocks lost nearly $16 billion in the month of October or 18% of the beginning of the month value. Twenty-nine public utilities (tabulated by the New York Times) lost $5.1 billion in the month, by far the largest loss of any of the industries listed by the Times. The value of the stocks of all public utilities went down by more than $5.1 billion.

An Interpretive Overview of Events and Issues

My interpretation of these events is that the statement by Snowden, Chancellor of the Exchequer, indicating the presence of a speculative orgy in America is likely to have triggered the October 3 break. Public utility stocks had been driven up by an explosion of investment trust formation and investing. The trusts, to a large extent, bought stock on margin with funds loaned not by banks but by “others.” These funds were very sensitive to any market weakness. Public utility regulation was being reviewed by the Federal Trade Commission, New York City, New York State, and Massachusetts, and these reviews were watched by the other regulatory commissions and by investors. The sell-off of utility stocks from October 16 to October 23 weakened prices and created “margin selling” and withdrawal of capital by the nervous “other” money. Then on October 24, the selling panic happened.

There are three topics that require expansion. First, there is the setting of the climate concerning speculation that may have led to the possibility of relatively specific issues being able to trigger a general market decline. Second, there are investment trusts, utility holding companies, and margin buying that seem to have resulted in one sector being very over-levered and overvalued. Third, there are the public utility stocks that appear to be the best candidate as the actual trigger of the crash.

Contemporary Worries of Excessive Speculation

During 1929, the public was bombarded with statements of outrage by public officials regarding the speculative orgy taking place on the New York Stock Exchange. If the media say something often enough, a large percentage of the public may come to believe it. By October 29 the overall opinion was that there had been excessive speculation and the market had been too high. Galbraith (1961), Kindleberger (1978), and Malkiel (1996) all clearly accept this assumption. the Federal Reserve Bulletin of February 1929 states that the Federal Reserve would restrain the use of “credit facilities in aid of the growth of speculative credit.”

In the spring of 1929, the U.S. Senate adopted a resolution stating that the Senate would support legislation “necessary to correct the evil complained of and prevent illegitimate and harmful speculation” (Bierman, 1991).

The President of the Investment Bankers Association of America, Trowbridge Callaway, gave a talk in which he spoke of “the orgy of speculation which clouded the country’s vision.”

Adolph Casper Miller, an outspoken member of the Federal Reserve Board from its beginning described 1929 as “this period of optimism gone wild and cupidity gone drunk.”

Myron C. Taylor, head of U.S. Steel described “the folly of the speculative frenzy that lifted securities to levels far beyond any warrant of supporting profits.”

Herbert Hoover becoming president in March 1929 was a very significant event. He was a good friend and neighbor of Adolph Miller (see above) and Miller reinforced Hoover’s fears. Hoover was an aggressive foe of speculation. For example, he wrote, “I sent individually for the editors and publishers of major newspapers and magazine and requested them systematically to warn the country against speculation and the unduly high price of stocks.” Hoover then pressured Secretary of the Treasury Andrew Mellon and Governor of the Federal Reserve Board Roy Young “to strangle the speculative movement.” In his memoirs (1952) he titled his Chapter 2 “We Attempt to Stop the Orgy of Speculation” reflecting Snowden’s influence.

Buying on Margin

Margin buying during the 1920’s was not controlled by the government. It was controlled by brokers interested in their own well-being. The average margin requirement was 50% of the stock price prior to October 1929. On selected stocks, it was as high as 75%. When the crash came, no major brokerage firm was bankrupted, because the brokers managed their finances in a conservative manner. At the end of October, margins were lowered to 25%.

Brokers’ loans received a lot of attention in England, as they did in the United States. The Financial Times reported the level and the changes in the amount regularly. For example, the October 4 issue indicated that on October 3 broker loans reached a record high as money rates dropped from 7.5% to 6%. By October 9, money rates had dropped further to below .06. Thus, investors prior to October 24 had relatively easy access to funds at the lowest rate since July 1928.

the Financial Times (October 7, 1929, p. 3) reported that the President of the American Bankers Association was concerned about the level of credit for securities and had given a talk in which he stated, “Bankers are gravely alarmed over the mounting volume of credit being employed in carrying security loans, both by brokers and by individuals.” The Financial Times was also concerned with the buying of investment trusts on margin and the lack of credit to support the bull market.

My conclusion is that the margin buying was a likely factor in causing stock prices to go up, but there is no reason to conclude that margin buying triggered the October crash. Once the selling rush began, however, the calling of margin loans probably exacerbated the price declines. (A calling of margin loans requires the stock buyer to contribute more cash to the broker or the broker sells the stock to get the cash.)

Investment Trusts

By 1929, investment trusts were very popular with investors. These trusts were the 1929 version of closed-end mutual funds. In recent years seasoned closed-end mutual funds sell at a discount to their fundamental value. The fundamental value is the sum of the market values of the fund’s components (securities in the portfolio). In 1929, the investment trusts sold at a premium — i.e. higher than the value of the underlying stocks. Malkiel concludes (p. 51) that this “provides clinching evidence of wide-scale stock-market irrationality during the 1920s.” However, Malkiel also notes (p. 442) “as of the mid-1990’s, Berkshire Hathaway shares were selling at a hefty premium over the value of assets it owned.” Warren Buffett is the guiding force behind Berkshire Hathaway’s great success as an investor. If we were to conclude that rational investors would currently pay a premium for Warren Buffet’s expertise, then we should reject a conclusion that the 1929 market was obviously irrational. We have current evidence that rational investors will pay a premium for what they consider to be superior money management skills.

There were $1 billion of investment trusts sold to investors in the first eight months of 1929 compared to $400 million in the entire 1928. the Economist reported that this was important (October 12, 1929, p. 665). “Much of the recent increase is to be accounted for by the extraordinary burst of investment trust financing.” In September alone $643 million was invested in investment trusts (Financial Times, October 21, p. 3). While the two sets of numbers (from the Economist and the Financial Times) are not exactly comparable, both sets of numbers indicate that investment trusts had become very popular by October 1929.

The common stocks of trusts that had used debt or preferred stock leverage were particularly vulnerable to the stock price declines. For example, the Goldman Sachs Trading Corporation was highly levered with preferred stock and the value of its common stock fell from $104 a share to less than $3 in 1933. Many of the trusts were levered, but the leverage of choice was not debt but rather preferred stock.

In concept, investment trusts were sensible. They offered expert management and diversification. Unfortunately, in 1929 a diversification of stocks was not going to be a big help given the universal price declines. Irving Fisher on September 6, 1929 was quoted in the New York Herald Tribune as stating: “The present high levels of stock prices and corresponding low levels of dividend returns are due largely to two factors. One, the anticipation of large dividend returns in the immediate future; and two, reduction of risk to investors largely brought about through investment diversification made possible for the investor by investment trusts.”

If a researcher could find out the composition of the portfolio of a couple of dozen of the largest investment trusts as of September-October 1929 this would be extremely helpful. Seven important types of information that are not readily available but would be of interest are:

  • The percentage of the portfolio that was public utilities.
  • The extent of diversification.
  • The percentage of the portfolios that was NYSE firms.
  • The investment turnover.
  • The ratio of market price to net asset value at various points in time.
  • The amount of debt and preferred stock leverage used.
  • Who bought the trusts and how long they held.

The ideal information to establish whether market prices are excessively high compared to intrinsic values is to have both the prices and well-defined intrinsic values at the same moment in time. For the normal financial security, this is impossible since the intrinsic values are not objectively well defined. There are two exceptions. DeLong and Schleifer (1991) followed one path, very cleverly choosing to study closed-end mutual funds. Some of these funds were traded on the stock market and the market values of the securities in the funds’ portfolios are a very reasonable estimate of the intrinsic value. DeLong and Schleifer state (1991, p. 675):

“We use the difference between prices and net asset values of closed-end mutual funds at the end of the 1920s to estimate the degree to which the stock market was overvalued on the eve of the 1929 crash. We conclude that the stocks making up the S&P composite were priced at least 30 percent above fundamentals in late summer, 1929.”

Unfortunately (p. 682) “portfolios were rarely published and net asset values rarely calculated.” It was only after the crash that investment trusts started to reveal routinely their net asset value. In the third quarter of 1929 (p. 682), “three types of event seemed to trigger a closed-end fund’s publication of its portfolio.” The three events were (1) listing on the New York Stock Exchange (most of the trusts were not listed), (2) start up of a new closed-end fund (this stock price reflects selling pressure), and (3) shares selling at a discount from net asset value (in September 1929 most trusts were not selling at a discount, the inclusion of any that were introduces a bias). After 1929, some trusts revealed 1929 net asset values. Thus, DeLong and Schleifer lacked the amount and quality of information that would have allowed definite conclusions. In fact, if investors also lacked the information regarding the portfolio composition we would have to place investment trusts in a unique investment category where investment decisions were made without reliable financial statements. If investors in the third quarter of 1929 did not know the current net asset value of investment trusts, this fact is significant.

The closed-end funds were an attractive vehicle to study since the market for investment trusts in 1929 was large and growing rapidly. In August and September alone over $1 billion of new funds were launched. DeLong and Schleifer found the premiums of price over value to be large — the median was about 50% in the third quarter of 1929) (p. 678). But they worried about the validity of their study because funds were not selected randomly.

DeLong and Schleifer had limited data (pp. 698-699). For example, for September 1929 there were two observations, for August 1929 there were five, and for July there were nine. The nine funds observed in July 1929 had the following premia: 277%, 152%, 48%, 22%, 18% (2 times), 8% (3 times). Given that closed-end funds tend to sell at a discount, the positive premiums are interesting. Given the conventional perspective in 1929 that financial experts could manager money better than the person not plugged into the street, it is not surprising that some investors were willing to pay for expertise and to buy shares in investment trusts. Thus, a premium for investment trusts does not imply the same premium for other stocks.

The Public Utility Sector

In addition to investment trusts, intrinsic values are usually well defined for regulated public utilities. The general rule applied by regulatory authorities is to allow utilities to earn a “fair return” on an allowed rate base. The fair return is defined to be equal to a utility’s weighted average cost of capital. There are several reasons why a public utility can earn more or less than a fair return, but the target set by the regulatory authority is the weighted average cost of capital.

Thus, if a utility has an allowed rate equity base of $X and is allowed to earn a return of r, (rX in terms of dollars) after one year the firm’s equity will be worth X + rX or (1 + r)X with a present value of X. (This assumes that r is the return required by the market as well as the return allowed by regulators.) Thus, the present value of the equity is equal to the present rate base, and the stock price should be equal to the rate base per share. Given the nature of public utility accounting, the book value of a utility’s stock is approximately equal to the rate base.

There can be time periods where the utility can earn more (or less) than the allowed return. The reasons for this include regulatory lag, changes in efficiency, changes in the weather, and changes in the mix and number of customers. Also, the cost of equity may be different than the allowed return because of inaccurate (or incorrect) or changing capital market conditions. Thus, the stock price may differ from the book value, but one would not expect the stock price to be very much different than the book value per share for very long. There should be a tendency for the stock price to revert to the book value for a public utility supplying an essential service where there is no effective competition, and the rate commission is effectively allowing a fair return to be earned.

In 1929, public utility stock prices were in excess of three times their book values. Consider, for example, the following measures (Wigmore, 1985, p. 39) for five operating utilities.

border=”1″ cellspacing=”0″ cellpadding=”2″ class=”encyclopedia” width=”580″>

1929 Price-earnings Ratio

High Price for Year

Market Price/Book Value

Commonwealth Edison

35

3.31

Consolidated Gas of New York

39

3.34

Detroit Edison

35

3.06

Pacific Gas & Electric

28

3.30

Public Service of New Jersey

35

3.14

Sooner or later this price bubble had to break unless the regulatory authorities were to decide to allow the utilities to earn more than a fair return, or an infinite stream of greater fools existed. The decision made by the Massachusetts Public Utility Commission in October 1929 applicable to the Edison Electric Illuminating Company of Boston made clear that neither of these improbable events were going to happen (see below).

The utilities bubble did burst. Between the end of September and the end of November 1929, industrial stocks fell by 48%, railroads by 32% and utilities by 55% — thus utilities dropped the furthest from the highs. A comparison of the beginning of the year prices and the highest prices is also of interest: industrials rose by 20%, railroads by 19%, and utilities by 48%. The growth in value for utilities during the first nine months of 1929 was more than twice that of the other two groups.

The following high and low prices for 1929 for a typical set of public utilities and holding companies illustrate how severely public utility prices were hit by the crash (New York Times, 1 January 1930 quotations.)

1929
Firm High Price Low Price Low Price DividedBy High Price
American Power & Light 1753/8 641/4 .37
American Superpower 711/8 15 .21
Brooklyn Gas 2481/2 99 .44
Buffalo, Niagara & Eastern Power 128 611/8 .48
Cities Service 681/8 20 .29
Consolidated Gas Co. of N.Y. 1831/4 801/8 .44
Electric Bond and Share 189 50 .26
Long Island Lighting 91 40 .44
Niagara Hudson Power 303/4 111/4 .37
Transamerica 673/8 201/4 .30

Picking on one segment of the market as the cause of a general break in the market is not obviously correct. But the combination of an overpriced utility segment and investment trusts with a portion of the market that had purchased on margin appears to be a viable explanation. In addition, as of September 1, 1929 utilities industry represented $14.8 billion of value or 18% of the value of the outstanding shares on the NYSE. Thus, they were a large sector, capable of exerting a powerful influence on the overall market. Moreover, many contemporaries pointed to the utility sector as an important force in triggering the market decline.

The October 19, 1929 issue of the Commercial and Financial Chronicle identified the main depressing influences on the market to be the indications of a recession in steel and the refusal of the Massachusetts Department of Public Utilities to allow Edison Electric Illuminating Company of Boston to split its stock. The explanations offered by the Department — that the stock was not worth its price and the company’s dividend would have to be reduced — made the situation worse.

the Washington Post (October 17, p. 1) in explaining the October 16 market declines (an Associated Press release) reported, “Professional traders also were obviously distressed at the printed remarks regarding inflation of power and light securities by the Massachusetts Public Utility Commission in its recent decision.”

Straws That Broke the Camel’s Back?

Edison Electric of Boston

On August 2, 1929, the New York Times reported that the Directors of the Edison Electric Illuminating Company of Boston had called a meeting of stockholders to obtain authorization for a stock split. The stock went up to a high of $440. Its book value was $164 (the ratio of price to book value was 2.6, which was less than many other utilities).

On Saturday (October 12, p. 27) the Times reported that on Friday the Massachusetts Department of Public Utilities has rejected the stock split. The heading said “Bars Stock Split by Boston Edison. Criticizes Dividend Policy. Holds Rates Should Not Be Raised Until Company Can Reduce Charge for Electricity.” Boston Edison lost 15 points for the day even though the decision was released after the Friday closing. The high for the year was $440 and the stock closed at $360 on Friday.

The Massachusetts Department of Public Utilities (New York Times, October 12, p. 27) did not want to imply to investors that this was the “forerunner of substantial increases in dividends.” They stated that the expectation of increased dividends was not justified, offered “scathing criticisms of the company” (October 16, p. 42) and concluded “the public will take over such utilities as try to gobble up all profits available.”

On October 15, the Boston City Council advised the mayor to initiate legislation for public ownership of Edison, on October 16, the Department announced it would investigate the level of rates being charged by Edison, and on October 19, it set the dates for the inquiry. On Tuesday, October 15 (p. 41), there was a discussion in the Times of the Massachusetts decision in the column “Topic in Wall Street.” It “excited intense interest in public utility circles yesterday and undoubtedly had effect in depressing the issues of this group. The decision is a far-reaching one and Wall Street expressed the greatest interest in what effect it will have, if any, upon commissions in other States.”

Boston Edison had closed at 360 on Friday, October 11, before the announcement was released. It dropped 61 points at its low on Monday, (October 14) but closed at 328, a loss of 32 points.

On October 16 (p. 42), the Times reported that Governor Allen of Massachusetts was launching a full investigation of Boston Edison including “dividends, depreciation, and surplus.”

One major factor that can be identified leading to the price break for public utilities was the ruling by the Massachusetts Public Utility Commission. The only specific action was that it refused to permit Edison Electric Illuminating Company of Boston to split its stock. Standard financial theory predicts that the primary effect of a stock split would be to reduce the stock price by 50% and would leave the total value unchanged, thus the denial of the split was not economically significant, and the stock split should have been easy to grant. But the Commission made it clear it had additional messages to communicate. For example, the Financial Times (October 16, 1929, p. 7) reported that the Commission advised the company to “reduce the selling price to the consumer.” Boston was paying $.085 per kilowatt-hour and Cambridge only $.055. There were also rumors of public ownership and a shifting of control. The next day (October 17), the Times reported (p. 3) “The worst pressure was against Public Utility shares” and the headline read “Electric Issue Hard Hit.”

Public Utility Regulation in New York

Massachusetts was not alone in challenging the profit levels of utilities. The Federal Trade Commission, New York City, and New York State were all challenging the status of public utility regulation. New York Governor (Franklin D. Roosevelt) appointed a committee on October 8 to investigate the regulation of public utilities in the state. The Committee stated, “this inquiry is likely to have far-reaching effects and may lead to similar action in other States.” Both the October 17 and October 19 issues of the Times carried articles regarding the New York investigative committee. Professor Bonbright, a Roosevelt appointee, described the regulatory process as a “vicious system” (October 19, p. 21), which ignored consumers. The Chairman of the Public Service Commission, testifying before the Committee wanted more control over utility holding companies, especially management fees and other transfers.

The New York State Committee also noted the increasing importance of investment trusts: “mention of the influence of the investment trust on utility securities is too important for this committee to ignore” (New York Times, October 17, p. 18). They conjectured that the trusts had $3.5 billion to invest, and “their influence has become very important” (p. 18).

In New York City Mayor Jimmy Walker was fighting the accusation of graft charges with statements that his administration would fight aggressively against rate increases, thus proving that he had not accepted bribes (New York Times, October 23). It is reasonable to conclude that the October 16 break was related to the news from Massachusetts and New York.

On October 17, the New York Times (p. 18) reported that the Committee on Public Service Securities of the Investment Banking Association warned against “speculative and uniformed buying.” The Committee published a report in which it asked for care in buying shares in utilities.

On Black Thursday, October 24, the market panic began. The market dropped from 305.87 to 272.32 (a 34 point drop, or 9%) and closed at 299.47. The declines were led by the motor stocks and public utilities.

The Public Utility Multipliers and Leverage

Public utilities were a very important segment of the stock market, and even more importantly, any change in public utility stock values resulted in larger changes in equity wealth. In 1929, there were three potentially important multipliers that meant that any change in a public utility’s underlying value would result in a larger value change in the market and in the investor’s value.

Consider the following hypothetical values for a public utility:

Book value per share for a utility $50

Market price per share 162.502

Market price of investment trust holding stock (assuming a 100% 325.00

premium over market value)

Eliminating the utility’s $112.50 market price premium over book value, the market price of the investment trust would be $50 without a premium. The loss in market value of the stock of the investment trust and the utility would be $387.50 (with no premium). The $387.50 is equal to the $112.50 loss in underlying stock value and the $275 reduction in investment trust stock value. The public utility holding companies, in fact, were even more vulnerable to a stock price change since their ratio of price to book value averaged 4.44 (Wigmore, p. 43). The $387.50 loss in market value implies investments in both the firm’s stock and the investment trust.

For simplicity, this discussion has assumed the trust held all the holding company stock. The effects shown would be reduced if the trust held only a fraction of the stock. However, this discussion has also assumed that no debt or margin was used to finance the investment. Assume the individual investors invested only $162.50 of their money and borrowed $162.50 to buy the investment trust stock costing $325. If the utility stock went down from $162.50 to $50 and the trust still sold at a 100% premium, the trust would sell at $100 and the investors would have lost 100% of their investment since the investors owe $162.50. The vulnerability of the margin investor buying a trust stock that has invested in a utility is obvious.

These highly levered non-operating utilities offered an opportunity for speculation. The holding company typically owned 100% of the operating companies’ stock and both entities were levered (there could be more than two levels of leverage). There were also holding companies that owned holding companies (e.g., Ebasco). Wigmore (p. 43) lists nine of the largest public utility holding companies. The ratio of the low 1929 price to the high price (average) was 33%. These stocks were even more volatile than the publicly owned utilities.

The amount of leverage (both debt and preferred stock) used in the utility sector may have been enormous, but we cannot tell for certain. Assume that a utility purchases an asset that costs $1,000,000 and that asset is financed with 40% stock ($400,000). A utility holding company owns the utility stock and is also financed with 40% stock ($160,000). A second utility holding company owns the first and it is financed with 40% stock ($64,000). An investment trust owns the second holding company’s stock and is financed with 40% stock ($25,600). An investor buys the investment trust’s common stock using 50% margin and investing $12,800 in the stock. Thus, the $1,000,000 utility asset is financed with $12,800 of equity capital.

When the large amount of leverage is combined with the inflated prices of the public utility stock, both holding company stocks, and the investment trust the problem is even more dramatic. Continuing the above example, assume the $1,000,000 asset again financed with $600,000 of debt and $400,000 common stock, but the common stock has a $1,200,000 market value. The first utility holding company has $720,000 of debt and $480,000 of common. The second holding company has $288,000 of debt and $192,000 of stock. The investment trust has $115,200 of debt and $76,800 of stock. The investor uses $38,400 of margin debt. The $1,000,000 asset is supporting $1,761,600 of debt. The investor’s $38,400 of equity is very much in jeopardy.

Conclusions and Lessons

Although no consensus has been reached on the causes of the 1929 stock market crash, the evidence cited above suggests that it may have been that the fear of speculation helped push the stock market to the brink of collapse. It is possible that Hoover’s aggressive campaign against speculation, helped by the overpriced public utilities hit by the Massachusetts Public Utility Commission decision and statements and the vulnerable margin investors, triggered the October selling panic and the consequences that followed.

An important first event may have been Lord Snowden’s reference to the speculative orgy in America. The resulting decline in stock prices weakened margin positions. When several governmental bodies indicated that public utilities in the future were not going to be able to justify their market prices, the decreases in utility stock prices resulted in margin positions being further weakened resulting in general selling. At some stage, the selling panic started and the crash resulted.

What can we learn from the 1929 crash? There are many lessons, but a handful seem to be most applicable to today’s stock market.

  • There is a delicate balance between optimism and pessimism regarding the stock market. Statements and actions by government officials can affect the sensitivity of stock prices to events. Call a market overpriced often enough, and investors may begin to believe it.
  • The fact that stocks can lose 40% of their value in a month and 90% over three years suggests the desirability of diversification (including assets other than stocks). Remember, some investors lose all of their investment when the market falls 40%.
  • A levered investment portfolio amplifies the swings of the stock market. Some investment securities have leverage built into them (e.g., stocks of highly levered firms, options, and stock index futures).
  • A series of presumably undramatic events may establish a setting for a wide price decline.
  • A segment of the market can experience bad news and a price decline that infects the broader market. In 1929, it seems to have been public utilities. In 2000, high technology firms were candidates.
  • Interpreting events and assigning blame is unreliable if there has not been an adequate passage of time and opportunity for reflection and analysis — and is difficult even with decades of hindsight.
  • It is difficult to predict a major market turn with any degree of reliability. It is impressive that in September 1929, Roger Babson predicted the collapse of the stock market, but he had been predicting a collapse for many years. Also, even Babson recommended diversification and was against complete liquidation of stock investments (Financial Chronicle, September 7, 1929, p. 1505).
  • Even a market that is not excessively high can collapse. Both market psychology and the underlying economics are relevant.

References

Barsky, Robert B. and J. Bradford DeLong. “Bull and Bear Markets in the Twentieth Century,” Journal of Economic History 50, no. 2 (1990): 265-281.

Bierman, Harold, Jr. The Great Myths of 1929 and the Lessons to be Learned. Westport, CT: Greenwood Press, 1991.

Bierman, Harold, Jr. The Causes of the 1929 Stock Market Crash. Westport, CT, Greenwood Press, 1998.

Bierman, Harold, Jr. “The Reasons Stock Crashed in 1929.” Journal of Investing (1999): 11-18.

Bierman, Harold, Jr. “Bad Market Days,” World Economics (2001) 177-191.

Commercial and Financial Chronicle, 1929 issues.

Committee on Banking and Currency. Hearings on Performance of the National and Federal Reserve Banking System. Washington, 1931.

DeLong, J. Bradford and Andrei Schleifer, “The Stock Market Bubble of 1929: Evidence from Closed-end Mutual Funds.” Journal of Economic History 51, no. 3 (1991): 675-700.

Federal Reserve Bulletin, February, 1929.

Fisher, Irving. The Stock Market Crash and After. New York: Macmillan, 1930.

Galbraith, John K. The Great Crash, 1929. Boston, Houghton Mifflin, 1961.

Hoover, Herbert. The Memoirs of Herbert Hoover. New York, Macmillan, 1952.

Kendrick, John W. Productivity Trends in the United States. Princeton University Press, 1961.

Kindleberger, Charles P. Manias, Panics, and Crashes. New York, Basic Books, 1978.

Malkiel, Burton G., A Random Walk Down Wall Street. New York, Norton, 1975 and 1996.

Moggridge, Donald. The Collected Writings of John Maynard Keynes, Volume XX. New York: Macmillan, 1981.

New York Times, 1929 and 1930.

Rappoport, Peter and Eugene N. White, “Was There a Bubble in the 1929 Stock Market?” Journal of Economic History 53, no. 3 (1993): 549-574.

Samuelson, Paul A. “Myths and Realities about the Crash and Depression.” Journal of Portfolio Management (1979): 9.

Senate Committee on Banking and Currency. Stock Exchange Practices. Washington, 1928.

Siegel, Jeremy J. “The Equity Premium: Stock and Bond Returns since 1802,”

Financial Analysts Journal 48, no. 1 (1992): 28-46.

Wall Street Journal, October 1929.

Washington Post, October 1929.

Wigmore, Barry A. The Crash and Its Aftermath: A History of Securities Markets in the United States, 1929-1933. Greenwood Press, Westport, 1985.

1 1923-25 average = 100.

2 Based a price to book value ratio of 3.25 (Wigmore, p. 39).

Citation: Bierman, Harold. “The 1929 Stock Market Crash”. EH.Net Encyclopedia, edited by Robert Whaples. March 26, 2008. URL http://eh.net/encyclopedia/the-1929-stock-market-crash/